- Long Financials. Financial stocks have performed miserably since 2002 as interest rates have dropped. Financials would rally if interest rates were to rise.
- Short medium to long US bonds, Bonds and interest rates trade inversely to each other. The 20 year and 30 year would fall if interest rates were to rise.
- The utility sector would also suffer if interest rates were to rise due to the sector’s high debt levels.
The Federal Reserve constantly state that it will be raising interest rates in the foreseeable future. To be honest, I find it difficult to believe. I believe the US economy is nowhere near ready for an interest rate hike. Nevertheless the FED keeps on stating that interest rates will rise sooner rather than later. Higher inflation levels would definitely prompt an interest rate hike. Therefore as investors, we should prepare strategies that would benefit us if this`happens. Lets go through some ETF’s that definitely would be affected by rising interest rates so we can be prepared for whatever the FED throws at us in the future.
Firstly take a look at the chart below which shows average fixed mortgage rates in the US since the year 2000.
As you can see, fixed mortgage rates have gone from roughly 8% to currently under 3%. Deposit interest rates are at practically 0% which means Americans have to look to other vehicles to give them a return on their money. So what asset classes have done well in the US over the last 15 years in a decreasing interest rate environment? The table below shows the ETF’s I used for my study.
|Select Sector Financial Slct Str SPDR Fd||(NYSEARCA:XLF)|
|Utilities SPDR (NYSEMKT:ETF)||(NYSEARCA:XLU)|
|iShares Dow Jones US Real Estate||(NYSEARCA:IYR)|
|SPDR S&P 500 ETF Trust||(NYSEARCA:SPY)|
|iShares Barclays 20+ Yr Treasury Bond||(NYSEARCA:TLT)|
I compared broad ETF’s in Financials, Utilities, Real Estate, S&P500 & the 20 year bond over the same period – 15 years. Here are the results.
|ETF Name||Ticker||15 Year Return|
|Select Sector Financial SPDR Fd||(NYSEARCA:XLF)||2.87%|
|iShares Dow Jones US Real Estate||(NYSEARCA:IYR)||128.31%|
|SPDR S&P 500 ETF Trust||(NYSEARCA:SPY)||42.61%|
|iShares Barclays 20+ Yr Treas.Bond||(NYSEARCA:TLT)||56.96%|
So what can we extrapolate from this study and how can we use these results to benefit our investing? I think the best sectors to trade would be bonds and utilities as their behaviour would be predictable. Real estate and stocks could continue to rally as more loans would be given out by the financials. However the obvious candidate to trade if interest rates were to rise would be the financial sector through (NYSEARCA:XLF). Rising interest rates benefit financial stocks for 2 obvious reasons
1. Banks make more money with higher interest rates as their margins increase
2. Rising interest rates usually mean an economy is recovering. More jobs and less unemployment usually means more financial activity (mortgages, personal loans, credit cards, etc.) and financials usually are the main benefactor.
The above 2 points are confirmed when you see the performance of the financial sector over the last 15 years ( less than 3%) .
Another good investment candidate in a rising interest rate environment would be short (NYSEARCA:TLT). Bonds trade inversely to interest rates and broad interest rates have been in decline since the start of 2014 whilst bonds have rallied (as shown in the chart)
Bonds and interest rates trade inversely to each other so shorting bonds (mid to long term) would bear fruit if interest rates rose. Potential Action – Short (NYSEARCA:TLT).
Finally the utility sector would also suffer in a rising interest rate environment. This sector usually carries a lot of debt so financing that debt would be difficult if interest rates rose. Potential Investment – Short (NYSEARCA:XLU)