The most recent Fed statement indicated the reserve bank is still on schedule to reduce its monthly bond purchases by this coming fall and speculation is now rising about when the first rate hike will come into play. The majority of economists and market watchers anticipate that a rate hike will be announced in the first half of 2015, but there are still many economic factors that could affect that decision.

This current release exhibited less concern about inflationary effects but a growing worry about the slack in the labor market. An improving jobs market is one of the economic signals that the Fed will use to determine the timing of fiscal policy tightening. This balancing of dovish and hawkish commentary is one reason to believe that the Fed is hedging their bets when it comes to keeping interest rates low for an extended period of time.

Over the years, investors have been trained not to bet against the Fed when it comes to decisions with their money. Staying with stocks and bonds since the inception of quantitative easing has been a profitable trade despite the overhang of long-term deficits and uncertain exit strategy. However, the time is rapidly approaching when the governments’ intervention in the financial markets is going to come to a close.

That may set loose a chain of events that has the potential to shake up your portfolio, particularly in the areas of interest-rate sensitive investments. Fortunately there are several ETFs that you can use to hedge your current exposure or balance your portfolio when the need arises.

Rising Interest Rates

One potential way to offset another 2013-style run up in Treasury bond yields is to consider a rising rates ETF such as the ProShares Short 20+ Year Treasury Bond ETF (TBF) or ProShares Short 7-10 Year Treasury Bond ETF (TBX). These funds allow you to profit when interest rates are rising because they short a basket of Treasuries according to an intermediate or long-duration index.

Small tactical allocations to these ETFs can help offset fluctuations in traditional fixed-income funds, while still allowing you to participate in the income stream that bonds generate. While I don’t recommend wholeheartedly shorting bonds outright, these rising rate ETFs can be employed within the context of a diversified income portfolio if the circumstances warrant their use.

Another avenue to consider is purchasing an ETF with a built-in hedge such as the ProShares Investment Grade-Interest Rate Hedged ETF (IGHG). This fund is designed to hold long positions in individual investment grade corporate bonds and short positions in U.S. treasuries. The strategy employed by IGHG all but eliminates the interest rate risk associated with a traditional bond fund. It has a current 30-day SEC yield of 3.44%, reasonable 0.30% expense ratio, and dividends are paid monthly to shareholders.

Rising Dollar

Another theme that has been taking shape recently is the rising U.S. dollar, which could continue to strengthen as foreign currencies such as the Euro weaken considerably. Fiscal tightening by the United States may be seen around the world as a power move to bolster our currency and reduce our dependence on loose monetary policy. We would also be the first major country to begin a tightening cycle prior to Europe or Japan engaging in these measures.

While the PowerShares U.S. Dollar Bullish Fund (UUP) is the most well-known ETF to track the strength of the buck, a new entrant has caught my attention as well. The WisdomTree Bloomberg U.S. Dollar Bullish Fund (USDU) is an ETF with a more balanced allocation to world currencies that include measuring the dollar versus both developed and emerging countries. USDU is also not subject to the K-1 tax headache that plagues an ETF such as UUP because it is not structured as a limited partnership. This may make it a more attractive vehicle for investors looking for a diversified and efficient way to track the progress of the U.S. dollar.

Financials

Assuming any aggressive Fed action is unlikely to derail the stock market momentum, the financial sector may be a way to profit on the equity side of the ledger. Banks have been recently underperforming as a result of heavy fines and reduced profitability on trading revenues. However, they may be looked at in a whole new light when lending rates begin to rise. These same financial institutions will see increased revenue on traditional banking and mortgage related activity that significantly improves their value in the eyes of shareholders.

The Financial Select Sector SPDR (XLF) is the largest and most well-known benchmark for this sector. This ETF has over $18 billion invested in a basket of banks, insurance companies, REITs, and consumer finance organizations. The SPDR S&P Bank ETF (KBE) and SPDR S&P Regional Banking ETF (KRE) are two additional funds that should be on your watch list as well.These two ETFs provide more targeted exposure to large institutions and geographical financial businesses that have the potential to outperform in a rising rate environment.

The Bottom Line

While future Federal Reserve policy changes will likely bring a new set of circumstances that we have yet to experience, having some of these tools in your arsenal will give you the flexibility to shift your asset allocation in response to changing trends. I recommend paying particularly close attention to Treasury bond yields and adapting to your current portfolio makeup rather than making wholehearted changes based strictly on a fundamental outlook.  As always, having a disciplined investment approach and implementing it decisively will produce superior results.