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ETF Areas Poised to Gain from Fed's Aggressive Tone

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Wall Street saw another dull trading session as the market felt the pressure of an aggressive Fed stance on rising inflation levels. The Dow Jones Industrial Average declined 0.4% on Apr 6. The other two broad market indices, the S&P 500 and the Nasdaq Composite, were also down 0.9% and 2.2%, respectively, on the same day.

The recently released FOMC minutes of the March meeting highlighted the central bank’s plans to control the inflation levels by larger interest rate hikes. It also outlined the method and magnitude of reducing the balance sheet that is holding around $9 trillion in assets. Notably, the Federal Reserve officials have decided to shrink their balance sheet by approximately $95 billion a month. More precisely, the Fed is planning to reduce $60 billion in Treasurys and $35 billion in mortgage-backed securities, phasing in over three months, starting May (per a CNBC article).

The minutes also mentioned that “Many participants noted that — with inflation well above the Committee’s objective, inflationary risks to the upside, and the federal funds rate well below participants’ estimates of its longer-run level — they would have preferred a 50 basis point increase in the target range for the federal funds rate at this meeting,” as stated in a CNBC article.

Notably, the Fed approved a 0.25 percentage point rate hike (the first increase since December 2018) on Mar 16. Following this hike, the benchmark interest rates are in a 0.25-0.5% range. At the same time, the central bank has informed about plans to increase interest rates six times this year.

The rising commodities prices due to the Russia-Ukraine war have added to the Federal Reserve’s concerns. Russia and Ukraine hold important positions as producers in the global commodities market. Thus, the escalation in tensions has sparked a rally in a broad range of commodities.

The latest developments can also slow down production activities and impact the export of commodities and goods. This is true as the tensions have led to supply disruption fears in an already-tight commodity market.

Against this backdrop, let’s take a look at some ETF areas that might look attractive and gain investor attention:

Banking ETFs

The shift toward a tighter monetary policy will push yields higher, thereby helping the financial sector. This is because rising rates will help in boosting profits for banks, insurance companies, discount brokerage firms and asset managers. The steepening of the yield curve (the difference between short and long-term interest rates) is likely to support banks’ net interest margins. As a result, net interest income, which constitutes a chunk of banks’ revenues, is likely to receive support from the steepening of the yield curve and a modest rise in loan demand. Notably, as the economy starts operating in full swing, the banking space will be able to generate more business.

Let’s take a look at some banking ETFs that can gain from the current environment: First Trust Nasdaq Bank ETF (FTXO - Free Report) , Invesco KBW Bank ETF (KBWB - Free Report) , Invesco KBW Regional Banking ETF (KBWR), iShares U.S. Regional Banks ETF (IAT) and SPDR S&P Regional Banking ETF (KRE) (read: Warren Buffett Wins in 2022: ETF Lessons to Learn From).

Insurance ETFs

The insurance industry makes up a considerable size of the financial sector. A reduction in bond buying can push bond prices down. This may increase the yield to maturity of bonds. Higher bond yields might raise the market's risk-free returns. A risk-free market interest rate hike can raise the cost of funds, enabling financial companies to widen the spread between longer-term assets, such as loans, with shorter-term liabilities, thus boosting the financial sector’s profits margin.

Insurance providers are generally compelled to hold several long-term safe bonds to back the policies written. A higher interest rate will benefit insurance companies. The spread between the longer-term assets and shorter-term liabilities will increase the spread of insurers. Moreover, the insurance industry's profitability has risen historically during the period of rising interest rates. SPDR S&P Insurance ETF (KIE - Free Report) and iShares U.S. Insurance ETF (IAK - Free Report) are good options for investors to consider (read: Insurance ETFs to Rally on Solid Q4 Earnings).

Floating Rate ETFs

Floating rate bonds are investment grade in nature and are not supposed to pay a fixed rate to investors. Instead, they have variable coupon rates that are often tied to an underlying index (such as LIBOR) plus a variable spread and are determined based on the credit risk of the issuers.

Since the coupons of these bonds are adjusted periodically, these are less sensitive to rising rates than traditional bonds. Unlike fixed coupon bonds, these do not lose value when the rates go up, making the bonds ideal for protecting investors against capital erosion in a rising rate environment.

Amid the current war scenario, the agressive stance of the Federal Reserve on hiking the benchmark interest rates have raised the appeal of floating-rate bonds. Since the coupons of these bonds are adjusted periodically, they are less sensitive to an increase in rates than traditional bonds. Against this backdrop, investors can consider ETFs like iShares Treasury Floating Rate Bond ETF (TFLO - Free Report) , iShares Floating Rate Bond ETF (FLOT - Free Report) and VanEck Investment Grade Floating Rate ETF (FLTR).