The Federal Reserve is likely to raise rates in December. At least that's what the markets are telling us. The implied probability of a rate hike based on Fed funds futures is currently 66 percent, up from 27 percent only a month ago.
For months, Fed officials have hinted that they would like to raise interest rates sometime this year, but choppy economic growth in the U.S. and even choppier growth outside the country have made the central bank reluctant to pull the trigger.
US Economy Strengthens
But now that may be changing. Two key economic data points released during the past month indicate that the world's largest economy may be strengthening despite head winds overseas.
ISM said that its nonmanufacturing index ticked up to 59.1 in October, a robust level that indicates strength in the U.S. services sector, the largest segment of the economy.
Shortly thereafter, the government reported that U.S. employers added 271,000 jobs in October, much more than analysts were predicting. That pushed the unemployment rate to a seven-year low of 5 percent.
Critically, average hourly earnings grew by 2.5 percent year-over-year in the month, the fastest pace since the financial crisis. Previously, Fed officials cited a lack of wage growth and a lack of inflation as reasons to hold off on hiking rates. Now that wages may be accelerating, that gives the central bank impetus to begin normalizing monetary policy.
Of course, financial markets aren't too excited about the prospect of the first rate increase in 9 ½ years. Ultra-low borrowing costs fueled strong gains in both stocks and bonds during the past several years.
With the zero-rate environment poised to end, certain asset classes and sectors may feel the pressure. But it's not all bad news; there are, in fact, some areas that stand to benefit from higher interest rates. Here are the exchange-traded funds that may be impacted by rising rates:
Bearish For Bond ETFs
Perhaps the most obvious impact from a Fed rate hike is on bonds, which move inversely with interest rates. All else equal, rising rates correspond with falling bond prices.
However, the impact on bond ETFs is not clear cut. When setting monetary policy, the Fed hikes its benchmark overnight interest rate―the Fed funds rate. Just because short-term rates are set to go up, doesn't mean medium- or long-term rates will necessarily rise in step.
They will certainly feel some upside pressure, but they could be held down by other factors, such as quantitative easing and extremely low rates in Japan and Europe (the German 10-year bond yield was last trading at a mere 0.62 percent).
In any case, some bond ETFs certainly look less appealing today than they did, say, a year ago. The iShares 20+ Year Treasury Bond ETF (TLT | A-83), for example, has lost 3.6 percent so far in 2015, and may struggle in the coming months.
Corporate bond ETFs, such as the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD | A-77) and the SPDR Barclays High Yield Bond ETF (JNK | B-68) will be negatively affected by rising rates, but if the economy performs better than expected, credit spreads could narrow, supporting prices.
Bullish For The Dollar
The biggest winner from Fed rate hikes may be the dollar. The greenback shot higher during the past few weeks as it became increasingly likely that the Fed will move soon. Up 13 percent last year, the U.S. Dollar Index is up another 10 percent so far this year.
The PowerShares DB US Dollar Index Bullish (UUP | B-73) has largely tracked the upward moves in the dollar against other major currencies such as the euro and yen.
Interestingly, the European Central Bank may be poised to expand its monetary stimulus in December just as the Fed begins to do the opposite by tightening policy. As long as this divergence in monetary policy between the Fed and other major central banks continues, the dollar stands to benefit.
Bullish For Currency-Hedged ETFs
Of course, if the dollar rallies from here, that'll be a shot in the arm for currency-hedged ETFs. The WisdomTree Japan Hedged Equity ETF (DXJ | B-67) and the WisdomTree Europe Hedged Equity ETF (HEDJ | B-50) are two extremely popular funds that may outperform on the back of dollar strength.
Of course, simply having a bullish dollar view is not a reason to buy into these ETFs in and of itself. It helps to have a bullish outlook for Japanese and European stocks as well.
That said, both these ETFs tilt toward owning stocks of export-orientated firms, which are direct beneficiaries of a rising dollar (and falling euro and yen).
Bearish For Gold
The flip side to the dollar's strength is weakness in gold. Considered an inflation hedge by many, higher interest rates (which discourage inflation) are anathema for the yellow metal. Gold bulls may argue that even after a number of hikes, interest rates will remain low by historical standards.
They would be right on that point, but nonetheless, there seems to be little reason to buy the safe-haven metal right now, and higher rates will merely sap what little appetite investors currently have for gold. The SPDR Gold Trust (GLD | A-100) is close to five-year lows and down 8.2 percent so far in 2015.
Bullish For Banks & Insurers
For most stock market sectors, higher interest rates are a net negative. The one exception is the financial sector, particularly banking and insurance stocks.
Higher rates bolster banks’ profits by increasing the spread between what they pay their depositors and the interest they earn on bonds and loans.
Similarly, higher rates boost the profitability of insurers by increasing the investment income they earn on their premiums.
Two popular ETFs tied to banks and insurers, respectively―the SPDR S&P Bank ETF (KBE | A-73) and the SPDR S&P Insurance ETF (KIE | A-72), have handily outperformed the broader stock market, with year-to-date returns of 9.8 percent and 9.3 percent, respectively.
Bearish For Utilities & REITs
In contrast to the banks and insurers are the interest-rate-sensitive areas of the market like utilities and REITs. Utilities, with their high yields, look less attractive when risk-free Treasury rates are rising. The Utilities Select SPDR ETF (XLU | A-88) is down 7.3 percent so far in 2015, making it the second-worst-performing major sector after energy.
Meanwhile, real estate investment trusts are in the same boat as utilities, with their relatively high yields. Additionally, they are exposed to any slowdown in the residential or commercial real estate market that arises from higher interest rates.
Like XLU, the Vanguard REIT ETF (VNQ | A-89) has underperformed the broader market so far this year, losing 2.1 percent. However, it's worth pointing out that rising interest rates don't necessarily spell doom for these sectors. In fact, during the last interest-rate tightening cycle, between 2004 and 2006, utilities and REITs actually outperformed the S&P 500.
Contact Sumit Roy at [email protected].