Hawkish commentary from the Federal Reserve (Fed) combined with a stronger-than-expected November jobs report have bolstered the market’s expectation for a December interest rate hike. In positioning for the first tightening cycle in nearly a decade, investors may want to consider regional banks, which have historically benefited from rising rates and a strengthening economy.
Federal Reserve Chair Janet Yellen said recently that a December interest rate increase was a “live possibility” if data continued to indicate the US economy was performing well.1The November jobs report hinted at just that—the unemployment rate remained at 5% and the economy added a higher-than-expected 211,000 jobs, with additional 35,000 added from prior month revisions.2 At the start of the quarter, the futures markets placed a 33% probability on a Fed rate increase before year-end. After two strong payroll reports and an upward revision of GDP growth, the probability soared past 70% and is at the highest level touched this year.3
Banking on a Fed hike with financials
SSGA currently expects the Fed to raise rates by 25 basis points at their December meeting. Should there be lift-off in December, we expect a series of four quarter-point rate hikes to follow in 2016. That means now may be an opportune time to prepare portfolios for rising rates, and we believe investors should pay attention not only to the fixed income side of their ledger but also to the equity side.
The financial sector is one of our preferred equity market segments in a rising rate environment because their returns have shown the most positive relationship to interest rate movements, as measured by the beta sensitivity to the 10 Year Treasury Yield, over the last 36 months. To more precisely harness the effects of rising rates, investors should consider the SPDR® S&P® Regional Banking ETF [NYSEarca: KRE]. KRE exhibits a strong positive relationship to rates—more so than the broader financial sector, as illustrated in the figure below.
Source: FactSet, State Street Global Advisors, as of 11/24/2015. Beta sensitivity of monthly returns over the last 36 months.
The case for regional banks
The early part of the tightening cycle is especially constructive for banks, as higher rates create more room to increase margins on their loans without stifling demand. For regional banks, mortgage financing is a primary business, and we expect demand for mortgages to increase as home prices rise and Americans head to their local bank to borrow money to buy a house. Regional banks also engage in commercial lending, and an improving economy will entice businesses to increase their borrowing to finance growth and investments.
Further, to the degree the Federal Reserve’s moves reflect its confidence in the economy, we’d expect lending activity to respond positively. This trend is beginning to emerge as the availability of credit for small businesses in the US improves, with conditions now at pre-recession levels.4 US consumer credit is also improving, and consumer loan balances, excluding government-held student loans, have finally exceeded their 2008 peak.5
By tracking an equal-weighted index, KRE provides deep market cap segmentation to
large-, mid- and small-cap firms. This results in little overlap with XLF and increased sector diversification, as demonstrated in the chart below. This allows KRE to help investors implement a cyclical view while harnessing a prominent growth driver of the financial sector.
Source: State Street Global Advisors, Bloomberg, as of 9/30/2015
To learn more about positioning for rising rates, you can download our article, Sectors & Industries: Top Three to Watch. You can also learn more about sector and industry investing by reading my blog series.