Market participants are keenly eyeing the Federal Reserve’s next move to squash high inflation levels. Speculations are rife that the central bank may hike rates by 0.75% at the end of the two-day policy meeting on Jun 15. To control hot inflation readings, the Fed hiked rates twice by 0.25% and 0.50% in 2022.
The central bank also plans to start reducing its huge $9-trillion balance sheet, comprising primarily Treasury and mortgage bonds, from June this year. It aims to begin with an initial combined monthly pace of $47.5 billion ($30 billion in Treasuries and $17.5 billion in mortgage-backed securities). That pace of reduction will span from June through August until September when the Fed will raise the cap up to $95 billion ($60 billion in Treasuries and $35 billion in mortgage-backed securities).
The latest release of hot inflation readings dashed hopes of inflation levels peaking in May. Per the latest Labor Department report, the Consumer Price Index (CPI) jumped 8.6% year over year in May (the maximum since 1981), surpassing the already high Dow Jones estimate of an 8.3% rise. The metric compared unfavorably with the 8.3% rise in April.
Energy, food and shelter stood out as major contributors to the surge in the index. Notably, energy prices rose 34.6% year over year, while gas prices jumped about 49%, according to a Yahoo Finance article. The core inflation index, which excludes volatile components, such as food and energy prices, rose 6% year over year, beating expectations of a 5.9% rise.
A Wall Street Journal report recently stated that the central bank might hike interest rates by 0.75% in the June meeting. The 10-year Treasury yields also jumped more than 20 basis points to surpass 3.3% on Jun 13 and topped 3.5% on Jun 14.
Against this backdrop, let’s look into some ETF areas that might look attractive and gain investor attention:
The shift toward a tighter monetary policy will push yields higher, thereby driving the financial sector. This is because rising rates will help 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.
As the economy starts operating in full swing, the banking space will be able to generate more business. The banking sector is well-poised to gain from a persistent surge in demand for loans, decent economic growth and efforts to diversify business that will provide support to banks’ top-line growth.
Let’s check out a few banking ETFs that can gain from the current environment:
First Trust Nasdaq Bank ETF ( FTXO Quick Quote FTXO - Free Report) , Invesco KBW Bank ETF ( KBWB Quick Quote KBWB - Free Report) , Invesco KBW Regional Banking ETF ( KBWR Quick Quote KBWR - Free Report) , iShares U.S. Regional Banks ETF (IAT) and SPDR S&P Regional Banking ETF (KRE) (read: JPMorgan's Rally Puts the Spotlight on Banking ETFs). Insurance ETFs
The insurance industry makes up a considerable size of the financial sector. A reduction in bond buying can pull 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, and shorter-term liabilities, thereby boosting the financial sector’s profit 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 rose historically during the period of increasing interest rates.
SPDR S&P Insurance ETF ( KIE Quick Quote KIE - Free Report) and iShares U.S. Insurance ETF ( IAK Quick Quote IAK - Free Report) are good options for investors to consider (read: Insurance ETFs to Gain on Solid Q1 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 the 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 and persistently high inflation levels, 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, these are less sensitive to increased rates than the traditional bonds. Against this backdrop, investors can consider ETFs like
iShares Treasury Floating Rate Bond ETF ( TFLO Quick Quote TFLO - Free Report) , iShares Floating Rate Bond ETF ( FLOT Quick Quote FLOT - Free Report) and VanEck Investment Grade Floating Rate ETF (FLTR).