The Utilities Select Sector SPDR (NYSEArca: XLU) is off by about 1.2% over the past week. That may not sound like much, but with bond markets implying an interest rate hike by the Federal Reserve is almost a sure thing this month, utilities stocks and exchange traded funds could be headed for declines.
Once the Fed eventually hikes interest rates, the higher rates will make fixed-income instruments more attractive on a relative basis, and bond-like equities, like utilities, less enticing. Consequently, utilities may remain flat or underperform other segments of the equities market once rates start ticking higher.
No sector is as negatively correlated to rising interest rates as utilities, meaning the longer the Fed resists raising interest rates, the longer high-yielding utilities stocks and ETFs remain compelling destinations for yield-starved investors.
“The sector has been hurt by the rise in long-term interest rates, which accelerated after the election. The rise in long-term interest rates lowers the multiple at which the utilities sector trades, since it is commonly regarded as a bond proxy, and bonds prices typically fall when interest rates rise,” according to a Franklin Templeton note seen on ETF Daily News.
XLU and rival utilities ETFs languished on the basis that fixed-income instruments more attractive on a relative basis, and bond-like equities, like utilities, less enticing.
The bond-esque utilities sector has also weakened alongside the fixed-income market as Treasury yields rose on the Fed outlook and inflationary pressures.
Utilities stocks and ETFs are extremely sensitive to changes in interest rates. Still, some investors see opportunity with rate-sensitive assets such as XLU and real estate ETFs, noting that 10-year yields are overbought and sentiment against the likes of XLU is at bearish extremes, which could create opportunity from the long side with the utilities sector.
“Many observers believe the industry has some earnings risk as a result of potential corporate tax reform. The actual impact will depend primarily on the specifics of the reform, with policies regarding interest-expense deductions and 100% depreciation expensing being the critical elements for the industry,” according to the Franklin Templeton note seen on ETF Daily News.
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