when the Fed decides to re-initiate a cycle of fiscal tightening. Essentially we are waiting for the Fed to lift the overnight lending rate from 0 to 0.25% or thereabouts.
The big debate of course is whether this is the perfect time to move the needle. Hawks point towards the statistically sound labor and economic data in the United States that has been trending higher for years. Doves on the other hand are firmly entrenched in worries over commodity deflation, emerging market weakness, currency instability, and tepid inflationary statistics.
Some worry that a rate increase has the potential to knock the U.S. market down even further on the heels of our first real correction since 2011. Others are concerned about the impact on Treasury yields and the trickle down effects to fixed-income, lending rates, credit cards, savings, etc…
It’s a real conundrum. But the important thing isn’t whether or not the Fed is going to raise rates. The real money will be made or lost in how the market reacts to the news.
There is the potential for swift moves in individual asset classes such as stocks, bonds, currencies, and commodities. Fixed-income markets in particular will be jittery given the fundamental link between conventional bond prices and interest rates.
Many experts have long touted the advantages of financial stocks during a period of rising interest rates. This is because it’s assumed that higher lending rates will contribute to higher margins for many of the companies that engage in investment and lending services.
The Financial Select Sector SPDR (NYSEARCA:XLF) is the largest and most well-known benchmark for this sector, with nearly $18 billion dedicated to 88 large-cap financial companies. XLF covers everything from big banks to insurance companies and REITs.
So far this year, XLF has posted a tepid return of -6% and will need to prove itself as a sector that will outperform on a real-world change in Fed policy. This ETFs performance will need to be judged relative to a broad-market benchmark such as the SPDR S&P 500 ETF (NYSEARCA:SPY).
It’s reasonable to assume that any significant volatility that hits SPY would likely make a similar impact in XLF as well. Nevertheless, it may be an ETF to watch closely as a key indicator.
Another asset class with a reputation to prove in a rising rate environment are floating rate notes and senior loans. The PowerShares Senior Loan Portfolio (NYSEARCA:BKLN) is an ETF with nearly $5 billion dedicated to bank loans with floating coupon rates. These securities function with a spread to LIBOR, which allows the coupon payments to adjust upward as interest rates rise.
Nevertheless, these floating rate securities are generally considered more credit sensitive and will react negatively to a deteriorating credit market (similar to junk bonds). BKLN has a current 30-day SEC yield of 5.23% and income is paid monthly to shareholders.
The Bottom Line
In my opinion there is no certain outcome when it comes to navigating a fiscal policy change as central and wide ranging as a rate hike. There are just too many variables at stake to place your faith in a specific and definable reaction. A truly “Fed-proof” investment is a myth.
I have heard many investors are so concerned with the changing landscape that they are going all to cash in an effort to avoid a global meltdown.
The problem with that theory is there is just as much likelihood that the stock market shrugs off the event and interest rates (set by the market) trend sideways or fall.
There is nothing wrong with having some dry powder on the sidelines to take advantage of new opportunities.
However, taking all your chips off the table may ultimately leave you playing catch up if a disaster fails to materialize.
As the saying goes, “Everyone has a plan until they get hit in the face”.
My advice is to stick with your current investment strategy with the caveat that you are flexible enough to make balanced and sensible changes as needed.
This article is brought to you courtesy of David Fabian.