NEW YORK, N.Y. – Interest rates could soon rise in the U.S. for the first time in almost a decade, and that’s shaking up financial markets.
Why all the anticipation? The Federal Reserve has held its benchmark rate close to zero since December 2008 to encourage borrowing and spending, and it’s been even longer since the Fed actually raised the cost of borrowing. The central bank last lifted rates in June 2006, the final hike in a two-year series of increases.
The Fed holds a policy meeting Tuesday. After a strong run of job growth in the U.S., investors will be watching closely for any insight into whether the central bank is considering raising rates. That’s a move that some analysts say could happen as early as June.
But investors aren’t waiting for the Fed. They’re already favouring stocks they think will do well under an improving economy — and the higher rates that come with it. They’re also steering away from investments they think will suffer.
Stocks of retailers and other companies that depend heavily on consumers are likely to keep rising as hiring expands, for example. But utilities and other high-dividend stocks are bound to languish as investors turn to bonds, which also pay steady income but carry less risk.
To be sure, any move by the Fed to lift rates is a vote of confidence in the U.S. economy. Higher rates are meant to combat inflation, which typically happens when wages and prices are rising as the job market improves.
Russ Koesterich, chief investment strategist at Blackrock, the money manager, says investors should expect “bigger drops and bigger swings” in the market as people scramble to adjust their portfolios after six years of near-zero rates. “This is going to be a change in the environment.”
Here’s a breakdown of potential winners and losers:
Utility stocks have been among the biggest losers this year. These stocks typically pay dividends that are high relative to their companies’ share prices. They were big winners just last year, when bond yields fell, and investors snapped up these stocks to receive income that they were no longer able to get from bonds.
Now, as yields have edged higher, these stocks are comparatively less attractive. The yield on the 10-year Treasury note, which had dropped as low has 1.64 per cent in January, is trading at 2.07 per cent. When higher rates are available on less risky bonds, dividend-paying stocks look less attractive by comparison.
Utilities have slumped 7 per cent in 2015, making them the biggest losers this year among the 10 industry groups that make up the S&P 500.
Other stocks that traditionally pay big dividends such as telecommunications companies and real estate investment trusts have struggled. Telecoms have fallen 3 per cent this month and Vanguard’s REIT exchange traded fund, which tracks REITs, is down 2 per cent.
Another by-product of a possible rate hike has been a surge in the dollar. The dollar index, which measures the strength of the U.S. currency against a basket of others, is up 10 per cent this year.
As the dollar climbs, companies that rely on overseas sales for a large portion of their revenues have seen their stocks slide.
Coca-Cola, which derives more than a third of its sales outside the U.S. has slumped 4.6 per cent this year. Procter & Gamble, owner of the Gillette and Crest brands, is down 8.3 per cent. The Standard & Poor’s 500 index is up 1.1 per cent over the same period.
Stores, restaurants and media companies should be among the better performers this year as the U.S. economy continues to strengthen and hiring picks up. Low gas prices will put more money in people’s pockets, also helping consumer-focused stocks.
Consumer discretionary stocks are the second-best performers of the sectors that make up the S&P 500. The industry group is up 5 per cent since the start of 2015.
Americans’ willingness to spend “isn’t going to be much affected by the rise in interest rates, it will be more impacted by the fact that the economy is getting better,” says Karyn Cavanaugh, senior market strategist at Voya Investment Management. “It’s a better economy, it’s a better job market, and that’s why the Fed is raising rates.”
The biggest threat to investors from rising rates could come from the investment considered the safest, namely U.S. Treasurys, says Jim Paulsen, chief investment strategist & economist at Wells Capital Management.
Prices for Treasury notes have rallied since the start of 2014, sending yields lower. The trend surprised many analysts who expected bond prices to fall as the Fed wound down a massive bond-buying program that was part of its effort to boost the U.S. economy. But as economies in other parts of the world struggled or slowed, investors bought more ultra-safe Treasurys, and drove prices higher.
Treasury prices are “very, very much out of line,” given the relative strength of the economy, says Paulsen. The unemployment rate has fallen to a seven-year low of 5.5 per cent, and most economists expect the economy to grow around 3 per cent this year. The yield on the 10-year Treasury note is 2.07 per cent, compared with a yield of 3 per cent six years ago during the last recession.
“The message from the bond market, supposedly, is that the world today is worse than it was than at any point during the Great Recession, which is nonsense,” says Paulsen.
His expectation is that Treasury prices will fall sharply, pushing the yield on the 10-year note as high as 3.25 per cent by the end of this year.
Of course, not all bonds are the same.
Junk bonds, riskier securities that pay higher yields than Treasurys, traditionally do well in a rising rate environment, says Rob Waldner, chief strategist at fund manager Invesco.
The bonds are issued by companies that have a relatively high amount of debt compared their earnings. The earnings of these companies typically rise when the economy is improving, and that offsets the impact of higher interest rates.
Junk-rated companies also tend to lock in their borrowing costs for a couple of years when they sell bonds, says Martin Fridson, chief investment officer at Lehmann Livian Fridson Advisors LLC. That means they are protected from the impact of higher rates, at least initially.
Since the start of the year, junk bonds have handed investors a 2 per cent return, according to the Barclays US High Yield index, which tracks the performance of the securities.
Municipal bonds, issued by local governments, also tend to do well for the same reason as junk bonds.
“In a rising rate environment, you have good growth going on and you have good credit quality,” says Invesco’s Waldner. “High yield almost always outperforms.”
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