Treasury yields have been on the rise in recent weeks with the 10-year yield approaching to the 3% level. Crossing this threshold could trigger financial shock waves as it did in 2013. Notably, the 10-year Treasury yields hit its highest level since January 2014 at 2.99% on Apr 23, pushing the gap (or spread) to German bonds the widest in 29 years.
A recent spike in commodity prices, especially oil and metals, has lifted inflation expectations, which in turn is fueling speculation of four rate hikes this year. Per the latest CME's FedWatch tracking tool, the market is projecting 50% chances of a total of four interest rate hikes this year. This compares to 33% probability a month ago and less than 40% late last week.
Pros and Cons
A rising rate environment is highly beneficial for cyclical sectors like financial, technology, industrials, and consumer discretionary. In particular, banks are at the most advantageous position as they seek to borrow money at short-term rates and lend at long-term rates. If interest rates rise, banks would be able to earn more on lending and pay less on deposits. This would expand net margins and bolster banks’ profits. Also, insurance companies are able to earn higher returns on their investment portfolio of longer-duration bonds (read: 5 ETFs to Play Rising Yields).
Higher rates would attract more capital to the country from foreign investors, thereby boosting the U.S. dollar against the basket of other currencies. However, this would have a huge impact on commodity-linked investments, reflecting that a rising rate environment will hurt a number of segments. In particular, high dividend paying sectors such as utilities and real estate would be the worst hit given their higher sensitivity to rising interest rates. Additionally, securities in capital-intensive sectors like telecom would also be impacted by higher rates.
Further, higher rates would also result in tighter lending conditions and curtail consumer spending on a wide range of products like cars and houses. This will in turn lower profitability across various segments.
Given this, we have highlighted three ETFs that will benefit from higher yields and the ones, which will badly impacted.
ETFs to Benefit
SPDR S&P Regional Banking ETF (KRE - Free Report)
This is one of largest and the most popular ETFs in the banking space with AUM of $4.9 billion and average daily volume of 6.7 million shares. The product follows the S&P Regional Banks Select Industry Index, charging investors 35 basis points a year in fees. Holding 120 securities in its basket, the fund is widely spread out across each security with an equal-weigh approach of around 2%. The fund has gained about 1.8% over the past week and carries a Zacks ETF Rank #1 (Strong Buy) with a High risk outlook (read: Bank ETFs Muted After Earnings: Should You Buy?).
Consumer Discretionary Select Sector SPDR Fund (XLY - Free Report)
This product offers exposure to the broad consumer discretionary space by tracking the Consumer Discretionary Select Sector Index. It is the largest and the most popular product in this space with AUM of $13.2 billion and average daily volume of around 5.8 million shares. Holding 82 securities in its basket, the fund is heavily concentrated on the top firm Amazon (AMZN - Free Report) at 21.1% while the other firms hold less than 7.2% of assets. The fund charges 0.13% in expense ratio and has gained 1.2% over the past week. It has a Zacks ETF Rank #1 with a Medium risk outlook (read: 4 Hot Sector ETFs Springing Up to Rank #1).
PowerShares DB US Dollar Bullish Fund (UUP - Free Report)
UUP offers exposure to a dollar against a basket of six world currencies. This is done by tracking the Deutsche Bank Long US Dollar Index Futures Index Excess Return plus the interest income from the fund’s holdings of U.S. Treasury securities. In terms of holdings, UUP allocates nearly 57.6% in euro and 25.5% collectively in the Japanese yen and British pound. The fund has so far managed an asset base of $516.7 million while sees an average daily volume of around 1.1 million shares. It charges 80 bps in annual fees and added 1.7% over the past week. The fund has a Zacks ETF Rank #3 (Hold) with a Medium risk outlook (read: Are Dollar ETFs Poised for More Losses in 2018?).
ETFs to Lose
iShares Mortgage Real Estate ETF (REM - Free Report)
This fund offers exposure to the U.S. residential and commercial mortgage real estate sectors by tracking the FTSE NAREIT All Mortgage Capped Index. It holds 36 securities in its basket with large allocations to the top two firms, Annaly Capital (NLY - Free Report) and AGNC Investment (AGNC - Free Report) , that collectively make up for 28.2% share while other securities hold less than 8.1% share. REM is the most popular mortgage REIT ETF with AUM of $998.5 million and average daily volume of around 350,000 shares. The fund charges 48 bps a year as fees and has lost 0.2% over the past week. It has a Zacks ETF Rank #4 (Sell) with a Medium risk outlook (read: Mortgage REIT ETFs Head to Head: REM vs. MORT).
SPDR S&P Homebuilders ETF (XHB - Free Report)
The most popular choice in the homebuilding space, XHB, follows the S&P Homebuilders Select Industry Index. In total, the fund holds about 35 securities in its basket with each accounting for less than 4.8% share. Homebuilding and building products account for 66.1% of the portfolio. The ETF has amassed $852.6 million in its asset base and trades in heavy volume of around 2.2 million shares. It charges 35 bps in fees per year and shed 1.9% over the past week. The fund has a Zacks ETF Rank #3 with a High risk outlook (read: Why Housing Stocks & ETFs Can Have a Spring in Their Step).
SPDR Gold Trust ETF (GLD - Free Report)
Gold will lose its sheen as higher interest rates would diminish the metal’s attractiveness and the product tracking this bullion like GLD will lose. The fund tracks the price of gold bullion measured in U.S. dollars, and kept in London under the custody of HSBC Bank USA. It is the ultra-popular gold ETF with AUM of $37.5 billion and average daily volume of around 7.4 million shares a day. Expense ratio comes in at 0.40%. The fund is down 1.6% over the past week and has a Zacks ETF Rank #3 with a Medium risk outlook (read: Why Silver ETFs May Outshine Gold ETFs).
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