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Fed Turns Hawkish: ETF Areas to Win

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As widely expected, the Fed effected the second-rate hike of the year in its June meeting. The Fed raised the benchmark interest rates by a modest 25 bps to 1.75-2.00%, confirming the U.S. economy’s growth momentum and the labor market’s well-being. It marked the seventh-rate hike since the first lift-off in December 2015.

The guidance for this year however turns a bit hawkish with a big section of policy makers seeking two more hikes this year, totaling four hikes in 2018. This is against the Fed’s previous projections of total three rate increases for this year.

The median estimate implied three hikes in 2019. Should these happen, the rates will reach a level beyond which monetary policy will neither be accommodative nor tight. Moreover, the Fed Chairman provided a relatively more bullish outlook of the U.S. economy.

Inside Upbeat Economic Forecast

The Fed upgraded its forecast for 2018 real GDP growth from 2.7% in March to 2.8% but maintained the 2019 and 2020 growth forecasts at 2.4% and 2.0%, respectively. The Fed projected the longer-run growth measure of 1.8%. Unemployment was guided down to 3.6% from 3.8% for 2018, 3.5% from 3.6% for 2019 and 3.5% from 3.6% for 2020.

PCE inflation expectations were upped from 1.9% to 2.1% for 2018 and 2.0% to 2.1% for 2019 but were kept intact at 2.1% for 2020. Core PCE inflation for 2019 and 2020 were the same while it was rasied to 2.0% from 1.9% for 2018.

Federal funds rate projections for 2018 were upped to 2.4% from 2.1% and to 3.1% from 2.9% for 2019 while remained the same for 2020. Over the longer term, the rate is projected at 2.9%, same as that of the March projections.

Market Reaction

The immediate impact should be felt in the bond market and the yield on 10-year U.S. Treasury increased to 2.98% from 2.96% recorded the day earlier. As the tightening move was largely expected, the Treasury market did not give any wild reaction. In fact, iShares 20+ Year Treasury Bond ETF (TLT - Free Report) shed about 0.1% on Jun 13 (read: ETF Strategies to Play the 7-Year High Benchmark Yield).

However, U.S. two-year Treasury yield rose to highest since 2008 to 2.59%. Stocks slumped amid fears of gradual ending in cheap money flows. Top U.S. ETFs like SPDR S&P 500 ETF (SPY - Free Report) (down 0.3%), SPDR Dow Jones Industrial Average ETF (DIA - Free Report) (down 0.4%) and PowerShares QQQ ETF (QQQ - Free Report) (down 0.01%) were in the red on Jun 13.

But there are no worries of a stock market crash. And there are several other ways to play the Fed policy tightening and bullish guidance. Below we highlight a few of them.

How to Profit From Fed Activity & Guidance?

Small-Cap

Investors should note that small-cap stocks are likely to do better in a rising rate environment since these are tied more to domestic activities and thus do not get hurt in a rising dollar environment (which is a likely outcome if interest rates rise). Also, with the GDP growth forecast being upgraded, investors have all reasons to play small-cap ETFs Invesco DWA SmallCap Momentum ETF (DWAS - Free Report) . The fund gained about 0.1% on Jun 13.

Consumer Discretionary

An improving economy with a strengthening labor market and a moderately rising interest rate environment is great for consumer discretionary stocks. First Trust Nasdaq Retail ETF (FTXD - Free Report) , which was up 0.6% on Jun 13, can be thus on investors’ wish list (read: Time to Buy Consumer Discretionary ETFs: 5 Top Picks).

Private Equity ETFs

As bond yields have started to rise, investors now need to focus on stable bets that offer way higher than the benchmark yield and private equity ETFs are known for this. Invesco Global Listed Private Equity ETF (PSP - Free Report) , which yields about 11.74% annually, added 0.3% on Jun 13. Private equity has a low correlation to the broader market but might underperform severely in the global meltdown, which is not the case presently.

Convertible Bonds

Stock markets being more-or-less steady, the U.S. economy on solid grounds and monetary policy normalizing, convertible bonds should be back in the limelight. Convertible bonds offer investors the right to convert their bond holdings into a company’s shares at the holder’s discretion. iShares Convertible Bond ETF (ICVT - Free Report) gained about 0.1% on Jun 13 (read: Why 2018 Could Be Great for Convertible Bond ETFs).

Interest Rate Hedged Bonds

Growing inflationary expectations and a booming economy should lead to an uptrend in Treasury yields. And this is the ideal situation to play interest rate hedged bond ETFs like ProShares High Yield Interest Rate Hedged (HYHG - Free Report) . The underlying index of the fund consists of a long position in high yield bonds and a duration-matched short position in U.S. Treasury securities. The fund also yields as high as 5.70% annually (read: Negative Duration Bond ETFs to Watch Amid Rising Yields).

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