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ECB Hikes Rates: ETFs to Win/Lose

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In line with many central banks, the European Central Bank (ECB) has raised interest rates by 50 bps to 0.5% (more than expected) — its first increase for more than a decade —to prevent high inflation.  Consumer prices rose at a record 8.6% year over year in June.

The rate had been negative since 2014 in a bid to shore up the region's long-ailing economy. The central bank’s deposit rate will now rise from minus 0.5% to zero, while the rate on its main refinancing operations will rise from zero to 0.5% and its marginal lending facility will increase from 0.25% to 0.75%. The ECB indicated that more hikes are possible as soon as its September 8 meeting.

In its June 2022 forecast, ECB predicted that inflation will average 6.8% in 2022, before falling to 3.5% in 2023 and meeting the ECB’s inflation target in 2024. The ECB then expected the real GDP growth to be 2.8% in 2022, 2.1% in 2023 and 2.1% in 2024.

The ECB also approved the Transmission Protection Instrument ("TPI"), a mechanism intended to ensure its monetary policy stance is "transmitted smoothly across all euro area countries." The action was taken in response to widening spreads among government bonds of different euro-area countries, as published on Seeking alpha.

Against this backdrop, below we highlight the a few prospective ETF winners following the ECB meeting.

Likely Winners

Invesco CurrencyShares Euro Currency Trust (FXE - Free Report)

Euro is on the way to record the best week since May after the ECB hiked rates. FXE added 0.34% on Jul 21 and added 0.7% after hours.

iShares MSCI Europe Financials ETF (EUFN - Free Report)

As the ECB hiked rates fatter-than-expected, the yield curve will likely steepen ahead. This is especially true given that the economic growth forecast has been decent despite the Russia-Ukraine war, energy prices rally and COVID-19 fears.

Financial stocks perform better in a rising rate environment. As banks seek to borrow money at short-term rates and lend at long-term rates, a steepening yield curve earns more on lending and pays less on deposits, thereby leading to a wider spread. This will expand net margins and increase banks’ profits. EUFN gained 1.9% on Jul 21 and added 3.4% after hours.

iShares MSCI Europe Small-Cap ETF (IEUS - Free Report)

The underlying MSCI Europe Small Cap Index captures small cap representation across the 15 Developed Markets countries in Europe. Small-cap stocks reflect the picture of the domestic economy better. Small-cap stocks generally have lower foreign exposure in their businesses. If the domestic currency gains, pint-size stocks do not feel the pain much as it has lesser export exposure. The fund IEUS added 1.9% on Jul 21.

Likely Losers

WisdomTree Europe Hedged Equity Fund (HEDJ - Free Report)

The fund gives exposure to large-cap Europe equities while giving protection against the rising greenback. With the euro gaining strength now, hedged ETFs are likely to underperform now. Plus, large-cap stocks have considerable foreign exposure and hence will underperform in a rising euro environment. HEDJ had added 1.1% in the key trading session on Jul 21. Though we do not expect such ETFs to lose, the magnitude of gains may be lower.