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Fed Rate Hike Warning: never say never…



  • 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?



Fed Rate Hike Warning: never say never…
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 (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) NYSEARCA: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 NYSEARCA:SHY (US); LON:IBTS (UK)).

An upward move in 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 NYSEARCA: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 (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 (SPDR S&P Banks NYSEARCA:KBE) (US); SPDR S&P US Financial Select Sector 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) 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 flipside, 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 be painful.




NOTICES: 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. This article has been written for a US and UK audience.  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.  For more information see www.elstonconsulting.co.uk Image credit: DodgertonSkillhause http://dodger.isinthehouse.com/
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