Investors Prepare for Higher Interest Rates

This article was written by Invesco PowerShares Senior Equity Product Strategist Nick Kalivas.

Over the past few months, the drumbeat of warnings about interest rate hikes from all quarters has continued unabated. The Federal Reserve has held the overnight fed funds rate near 0% since 2008, but few market observers doubt that today’s low interest rate environment will last much beyond 2015. Fed Chairman Janet Yellen has made no secret about the need for tighter monetary policy, remarking last month, “If the economy continues to improve, as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy.”¹

Indicators of higher interest rates on the horizon

But Yellen’s cautionary tone isn’t the only harbinger of potential changes to come. Consider these indicators, both stateside and abroad:

• After dropping as low as 1.64% in January, the yield on the benchmark 10-year Treasury note has now risen to levels in excess of 2.34%, flirting with 2015 highs.
• Employment rose for the seventh consecutive month in May, with the pace of jobs growth hitting a four-year record.
• The Federal Reserve’s June Beige Book indicated that nine of the 12 Federal Reserve districts reported either labor shortages or difficulty retaining employees. Moreover, the Beige Book noted unskilled and middle-tier jobs were seeing more wages increase.
• In Europe, parts of which are experiencing negative interest rates, there are signs of reflation, with the preliminary May German Consumer Price Index (CPI) rising 0.7% on a year-over-year basis, up from -0.5% in January.
• The European Central Bank has upgraded its inflation forecast for 2015 to 0.3% from 0%.

Somewhat less visible is the performance of dividend-paying stocks. As bond yields go up, dividend stocks tend to become relatively less attractive to investors. With bond yields currently heading north, utilities – a staple of the dividend stock universe – are the worst performing sector of the S&P 500 Index so far this year.

Higher rates could usher in more volatility

If the Federal Reserve does eventually pull the trigger on rate hikes, investors could likely experience an uptick in volatility. Last month, Federal Reserve Vice Chairman Stanley Fischer cautioned, “The actual raising of policy rates could trigger further bouts of volatility. We have done everything we can, within the limits of forecast uncertainty, to prepare market participants for what lies ahead.”² Given the prospect of higher rates, investors may wish to consider a low volatility investment approach and check their holdings for interest rate sensitivity. Over the past five years, financial stocks have been among the most sensitive to rising interest rates – especially insurance and diversified financial shares.

Unconstrained approach could be advantageous to investors

The PowerShares S&P 500 Low Volatility Fund (SPLV) may help investors stay prepared for a potential rise in interest rates. SPLV is a smart beta exchange-traded fund (ETF) designed to provide equity exposure with less risk than the overall market. In fact, since its May 2011 inception, SPLV has exhibited lower volatility than the S&P 500 Index.³ This is because the fund’s underlying index follows an unconstrained investment approach that allows for dynamic sector rotation.

Due to SPLV’s unconstrained sector rotations, the fund has shed much of its exposure to the underperforming utility sector over the past two years, from just over 30% in March 2013 to under 3% currently. Currently, SPLV’s allocation in utilities is 5% less than USMV (iShares MSCI USA Minimum Volatility ETF), which is subject to minimum-variance constraints, and also less than SPY (SPDR S&P 500 ETF Trust).⁴

SPLV’s largest sector allocation is now in financials, which have shown the greatest positive correlation to interest rates over the past one-year and five-year periods. The chart below illustrates SPLV’s dynamic sector allocation since September 2011.

SPLV’s underlying holdings, as determined by the S&P 500 Low Volatility Index, now show a five-year beta of 0.167 and a weighted-average correlation of 0.322 to the 10-year Treasury yield.⁵ Beyond the financial sector, SPLV is well-positioned to benefit from rising rates, given its overall sensitivity and correlation to the 10-year Treasury yield. The table below shows SPLV’s sector weights relative to the S&P 500 Index. Note that SPLV maintains a 19% higher weighting in financials than the S&P 500 Index.

S&P 500 Sector Sensitivity to the 10 Year Treasury Yield and SPLV & S&P 500 Sector Weights

I believe investors who have properly positioned their investment portfolios have little reason to fear rising interest rates and, in fact, may benefit from a higher interest rate environment.