Q. If the Fed to raise the rate soon, is Financial sector the sector to be for investors?
A. It's hard to say, because there could be 3 likely scenarios associated with the Fed raising rates.
Depending on which scenario will play out, the impact on financial sector's stocks could be dramatic.
If the Fed raises rates but there is no sign of inflation, banks could suffer. The reason is the banks' business model could be summarized as - borrow short term and lend long term. The Fed controls short term rates, but long term rates hinge on inflation expectation, if no sign of inflation, demand for long term bonds will rise, pushing prices higher and driving down yields. Banks suffer. Historical data also supports this statement, see below.
Average return after rate hike (since 1971, data source: S&P Capital IQ) -
In scenario 1, which subsector of Financials could outperform? Try local banks!
Local banks absorb local deposits, mostly with no interest checking accounts, therefore suffer less from the negativity from short term rate hikes. SPDR S&P Regional Banking ETF (KRE) is a good low cost tool to use to invest in this sector.
In our next blog post, we will discuss what to do in scenario 2.
A. It's hard to say, because there could be 3 likely scenarios associated with the Fed raising rates.
- Fed raises rates because the economy is doing great, with no sign of inflation;
- Fed raises rates because the economy is doing great, but inflation goes up;
- Fed raises rates and slows down the economy.
Depending on which scenario will play out, the impact on financial sector's stocks could be dramatic.
If the Fed raises rates but there is no sign of inflation, banks could suffer. The reason is the banks' business model could be summarized as - borrow short term and lend long term. The Fed controls short term rates, but long term rates hinge on inflation expectation, if no sign of inflation, demand for long term bonds will rise, pushing prices higher and driving down yields. Banks suffer. Historical data also supports this statement, see below.
Average return after rate hike (since 1971, data source: S&P Capital IQ) -
- Financials: -0.8%
- S&P 500: 2.4%
In scenario 1, which subsector of Financials could outperform? Try local banks!
Local banks absorb local deposits, mostly with no interest checking accounts, therefore suffer less from the negativity from short term rate hikes. SPDR S&P Regional Banking ETF (KRE) is a good low cost tool to use to invest in this sector.
In our next blog post, we will discuss what to do in scenario 2.
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