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As 2015 Begins, Fed’s Rate Hike Looms Large

7 January 2015 in Trading Ideas

A recent Barron’s article recalled that approximately one year ago today, Wall Street’s widespread Wall Street expectation for 2014 was that bond prices were going down and yields were going up, a result of the Federal Reserve steadily pulling back on its bond buying program.1

You might remember the cause-and-effect never materialized. As Barron’s noted, the Fed’s program ended in October, but bonds, especially longer-dated ones, rose throughout the year. The 30-year Treasury bond returned 30%, while its yield slipped to 2.8% from 4%.

In addition, against that backdrop, Barron’s said, most income investments performed well – REITS and utilities, in particular, soared.

One year later, here we are again, with expectations of rising interest rates. However, the difference now is that the case is made possibly stronger because those rising rates will be coming from the Fed’s own raising.

The central bank has kept its benchmark short-term interest rate pinned near zero since December 2008, through six years of the financial crisis, recession and slow recovery. Now, with the US experiencing relatively robust growth and strong hiring, the central bank is preparing to start pulling back its support.

Nearly all Fed policy makers predicted in December that the first rate increase would come this year, according to the Wall Street Journal. The precise timing and pace, however, remain unknown. Officials will weigh an improving labor market against sluggish inflation that has undershot the central bank’s 2% annual target for more than two-and-a-half years, the Journal said.2

The fall in global oil prices likely will drag inflation down further in the coming months.

In December, the Fed stressed patience. Chairwoman Janet Yellen said it was unlikely the Fed would begin raising rates at its next two policy meetings, scheduled for Jan. 27-28 and March 17-18.

Still, the rising-rate issue is likely a question of when, and not if. For investors, it may be time to determine where to turn in an era of rising rates.

One possibility that may be worth a further look is the Rising Interest Rates motif, a portfolio of six stocks of custodian banks and brokers whose business models could see benefits from the impact of higher rates on the cash they hold – specifically from higher net interest margins, but also higher loan volumes that a recovering economy should generate.

The Rising Interest Rates motif has gained 3.1% in the past month. The S&P 500 has lost 0.2% in that same period.

In the past 12 months, the motif has gained 9.4%; the S&P 500 is up 12.9%.

Shares of US banks have been in an uptrend for years, but they trailed the S&P 500 in 2014, and are similarly lagging over the past five years.

As a recent Financial Times piece suggested, that bank stocks are not outperforming amid an economic recovery could give investors pause as to whether faith in financials is something less than in the heady days before the financial crisis.3

On the other hand, for the last five years, banks have operated with 10-year interest rates of below 4%. A move back toward that level could change the equation for investors.

1Jack Hough, “Best Income Ideas for 2015,” barrons.com, Jan. 3, 2015.

2Ben Leubsdorf, “As Fed Prepares to Raise Rates, Economists Warn of Potential Bumps,” wsj.com, Jan. 4, 2015.

3Lex column, “Bank shares: a story of lost trust,” ft.com, Jan. 1, 2015.