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Investors Brace for Life After Rate Hike

15 December 2015 in Trading Ideas

The expectation that the Federal Reserve will raise short-term interest rates this week has been bandied about for weeks, if not months, but financial market behavior last week was anything but old news.

Oil prices plunged, the high-yield bond market unraveled, and stocks registered their worst performance in four months. All of it felt like a prelude to Wednesday, when the Fed will almost certainly raise interest rates for the first time in nine years.1

“The withdrawal of Fed policy creates these hissy fits,” Peter Boockvar, chief market analyst at The Lindsey Group, told Barron’s. “It’s pretty clear everyone expects it to happen, and the decision comes with so much baggage.”

Some traders believe a rate increase is an important milestone on the long road back from the financial crisis and toward markets less dependent on central banks.

But others say the expected move is likely to usher in an era of instability.

“Many investors in the market have never experienced a rising rate environment, which only increases the chance for volatility to pick up next year,” Thomas Roth of Mitsubishi UFJ Securities (USA) told the Wall Street Journal.2

Despite the expected volatility, many investors have been aiming to align their portfolios with sectors that could perform well in a higher-rate environment.

Bank equities have long been viewed as an obvious beneficiary, such as those stocks comprising the Rising Interest Rates motif.

In the past 12 months, the motif has gained 8.4%. In that same time, the S&P 500 has increased 0.5%.

But earlier this week, the Journal suggested other winners, at least in the near term: asset managers and online brokers.3

Take for instance Charles Schwab Corp (NYSE:SCHW), which has a 16.6% weighting in the Rising Interest Rates motif. According to the Journal, the investment firm has diversified its business well beyond just trading commissions. Through the first three quarters of the year, some $1.8 billion, or 39%, of Schwab’s total revenue came from net interest revenue — the difference between interest earned on assets and interest paid out on deposits.

If short-term rates were higher (as they could be after Wednesday), that figure would be higher. Schwab estimates that the Fed increasing rates by one percentage point would translate to a 37% increase in net interest revenue, the Journal said.

Rising rates also could have material effects on the $2.7 trillion money-market-fund industry and its prominent players—Fidelity Investments, JPMorgan Chase & Co (NYSE:JPM), Schwab, and Goldman Sachs Group Inc (NYSE:GS), among others. With yields near zero, asset managers have been forced to waive fees that otherwise would have eaten into investors’ principal, the Journal explained. (Shares of JPMorgan and Goldman Sachs have a combined 23.2% weighting in the Too Big to Fail motif, which is down 2.1% in the past 12 months).

Schwab, for instance, says fee waivers for money-market funds cost it $166 million in the third quarter. That’s a large amount, particularly compared with its $376 million in net income for the same period.

The Fed eventually raising short-term rates by one percentage point – they’re likely only planning a quarter-point hike on Wednesday — would likely remove the need for such waivers, according to Schwab.

Economists surveyed by the Journal don’t see the Fed’s benchmark short-term rate rising above 1% until December 2016, which could come even slower if the economic recovery stalls or become more sluggish.

On the other hand, practically nobody thinks the wait for a further hike will take anywhere near as long as this one has taken.

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  1. Avi Salzman, “Stocks Drop 3.8% in Overture to Fed Meeting,” barrons.com, Dec. 12, 2015.
  2. Dan Strumpf, Sauma Vaishampayan, and Min Zeng, “Ahead of the Fed: Tectonic Shifts in Bonds, Oil and the Dollar,” wsj.com, Dec. 13, 2015.
  3. Steven Russolillo, “A Fed Move Would Create Some Winners,” wsj.com, Dec. 13, 2015.