Fed Rate Hike Warning: Never Say Never...

by: Henry Cobbe, CFA

FOMC Board Minutes suggest potential interest rate rise next month.

Futures market pricing a 32% chance of a hike in June, compared to a 6% chance last week and a 4% chance a fortnight ago: markets expectations are adjusting accordingly.

If rate hike becomes more likely, this is potentially negative for risk- and rate-sensitive asset, and gold. Positive for dollar, short-dated bonds and financials.

Will Fed watch the economy, or the markets?

Prospects of rising interest rates sooner than the market had become ready to expect will pull away the prop for equities and hence negative equities. The S&P500 (NYSEARCA:SPY) (NYSEARCA:IVV) (US); LON:CSPX (UK) has dropped to a seven week low, and is now flat on the year, weighing down global equities, i.e., iShares MSCI ACWI Index Funds (NASDAQ:ACWI) (US); Vanguard FTSE All World Index LON:VWRD (UK).

The increased chance of a Fed rate hike creates downside risk at the long end of the yield curves, e.g., iShares $ Treasury Bonds 20+ year (NASDAQ:TLT) (US); LON:IDTL (UK), and for corporate bonds (e.g., iShares $ Corporate Bonds) (NYSEARCA:LQD) (US); LON:LQDE (UK). Perhaps most at risk are high-yield bonds with the double whammy of rate rises and on valuations where investor thirst for income has led to yields being potentially over-bid, e.g., iShares $ High Yield Corporate Bonds) (NYSEARCA:HYG) (US); LON:SHYU (UK). On the flipside, there is a potential offset as the improving economic backdrop could make the case for tightening spreads.

Within the bond sector, shorter duration bonds will be less exposed (e.g. iShares $ Treasury Bonds 1-3yrs (NASDAQ:SHY) (US); LON:IBTS (UK).

An upward move in the Fed Funds rate would be positive for the dollar and hence short-dated/ultra-short dated treasuries, as the ability of earning risk-free returns on cash once again become a more likely prospect e.g., iShares Short Treasury Bonds (NASDAQ:SHV) (US), PIMCO Enhanced Short Maturity Active (NYSEARCA:MINT) (US); iShares $ Ultrashort Bonds LON:ERND (UK).

On a relative basis, a Fed Funds hike may see relative weakness in Gold, i.e., SPDR Gold Shares (NYSEARCA:GLD) (US); ETFS Physical Gold LON:PHAU (UK)

On a sector specific-basis, rising rates is a positive indicator for net interest margins which is supportive for banks/financials, i.e., SPDR S&P Banks (NYSEARCA:KBE) (US); SPDR S&P US Financial Select Sector (NYSEARCA:XLF) LON:SXLF (UK), FRA:ZPDF.

By contrast a hike would be negative for long-duration/rate-sensitive sectors such as Utilities & Financials, Utilities Select SPDR ETF (NYSEARCA:XLU) (US); SPDR S&P US Financial Select Sector UCITS ETF LON:SXLU (UK), and FRA:ZPDU).

Property/real estate sector would likewise be negatively impacted as spreads between property yields over risk-free rate contracts: iShares Global REIT (NYSEARCA:REET) (US); iShares Developed Markets Property Yield LON:IWDP (UK). On the flip-side, any uptick in the economy could be an offsetting factor.

Risk assets love the "lower for longer" support of ultra-low interest rates. Readjustment to rising costs of capital could continue to be painful.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article has been written for a US and UK readership. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice.