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ETF Areas to Consider as Fed Remains Super Hawkish

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Market participants continue to grapple with rising Treasury yield and the Fed’s aggressive stance on interest rate hikes to control inflation levels. Reversing a rally on upbeat corporate earnings results, Wall Street ended Apr 21 with all major averages in the red. The Dow Jones Industrial Average declined 1.1% on the same day. The other two broad market indices, the S&P 500 and the Nasdaq Composite, were also down 1.5% and 2.1%, respectively, in yesterday’s trading session.

The benchmark 10-year Treasury yields remained above 2.9% (close to the highest level since late 2018) during most of the trading session on Apr 21 (per a CNBC article). The treasury yields have been climbing this year from 1.5%, largely due to the Fed’s aggressive stance on interest rate hikes.

The upside in benchmark yields was observed majorly due to Fed Chairman Jerome Powell indicating aggressive rate hikes next month. In this regard, Powell mentioned at the International Monetary Fund Debate on the Global Economy that it will be “appropriate in my view to be moving a little more quickly,” as stated in a CNBC article. He also mentioned that “I also think there is something to be said for front-end loading any accommodation one thinks is appropriate. ... I would say 50 basis points will be on the table for the May meeting,” per the same article as mentioned above.

Market experts fear Fed’s aggressive stance causing a slowdown in the U.S. economic recovery. Commenting on the market conditions, Joseph Kalish, chief global macro strategist at Ned Davis Research has said that “Although we expect inflation to peak very soon, if it hasn’t already done so, continued supply chain disruptions and a slow increase in labor force participation due to retirements and continued concerns over Covid, could easily keep the inflation rate more than double the Fed’s 2% target. As a result, the Fed may need to hike rates more than the peak 3.25% to 3.50% range currently priced into the markets a year from now,” per a CNBC article.

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 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 plans 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.

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 - Free Report) , iShares U.S. Regional Banks ETF (IAT) and SPDR S&P Regional Banking ETF (KRE) (read: What's in Store for Bank ETFs This Earnings Season?).

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) are good options for investors to consider.

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 high chances of the Federal Reserve 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), iShares Floating Rate Bond ETF (FLOT) and VanEck Investment Grade Floating Rate ETF (FLTR).