How to Use Unique Sector Insights to Protect Your Money from the Fed
Sam Subramanian PhD, MBA
By tracking returns of specific sectors relative to the S&P 500, investors can get a leg up on the timing of the Fed hiking interest rates.
New York Fed President William Dudley recently said, 'The Fed's first rate increase since 2006 will usher in a "regime shift" that will stir financial markets when it occurs.'
When will the Federal Reserve raise interest rates? This question is weighing on investors' minds in 2015.
Recent economic data increased optimism the Fed will defer raising interest rates for some time.
The Commerce Department reported gross domestic product grew at a lackluster 0.2% annualized rate in the first quarter of this year.
The Labor department reported payrolls increased 223,000 in April after gaining just 85,000 in March, the lowest monthly gain since June 2012. Average hourly earnings rose a tepid 0.1% in April, implying a 2.2% year-over-year increase in wages.
These data points gave economists & investors some comfort that growth is not rapid enough to warrant higher interest rates right away.
Yet, bond yields have not backed off after surging since the end of the first quarter. As of May 13, the yield on the 10-year Treasury bond stood 35 basis points above its March 31 level at 2.28%.
With the Fed having a limited hold on long-term interest rates, financial markets appear to be bearing the burden of tightening monetary conditions. The rise in bond yields raises corporate borrowing costs making expansion harder.
Stock investors are concerned on this abrupt shift in sentiment in the bond market.
Relative Returns of Sectors Often Foretell Shift in Fed Policy
The Fed usually has to see increasing demand for goods & services or a threat of inflation before raising interest rates.
With this in mind, AlphaProfit recently analyzed the performance of different sectors relative to the S&P 500 in the six-month period leading up to a first interest rate hike. AlphaProfit used Select Sector SPDR ETFs returns to quantify sector performance.
This analysis shows economically sensitive sectors like energy and industrials perform distinctly better than interest rate sensitive ones like utilities in the six months preceding a first interest rate hike.
Energy Select Sector SPDR (XLE) and Industrial Select Sector SPDR (XLI) outperformed Utilities Select Sector SPDR (XLU) and SPDR S&P 500 (SPY) during the six months ahead of the last two interest rate tightening cycles initiated by the Fed on June 30, 2004 and June 30, 1999.
Source: Morningstar, AlphaProfit
Average Returns of Energy Select Sector SPDR, Industrial Select Sector SPDR, and Utilities Select Sector SPDR vis-à-vis SPDR S&P 500 from Dec. 31, 1998 to Jun. 30, 1999 and from Dec. 31, 2003 to Jun. 30, 2004.
What do Relative Returns of Sectors Say the Fed will do now?
Energy Select Sector SPDR, Industrial Select Sector SPDR, and Utilities Select Sector SPDR have lagged the SPDR S&P 500 over the past six months. These data are consistent with the consensus view on the Fed not raising rates right away.
Source: Morningstar, AlphaProfit
Relative Return of Energy Select Sector SPDR, Industrial Select Sector SPDR, and Utilities Select Sector SPDR from Nov. 15, 2014 to May 15, 2015.
Energy stocks bottomed in mid-January and have rallied since then. Meanwhile, utility stocks have trailed the broad market.
As such, the relative return picture changes when the period between Nov. 15, 2014 and Jan. 14, 2015 is excluded.
Source: Morningstar, AlphaProfit
Relative Return of Energy Select Sector SPDR, Industrial Select Sector SPDR, and Utilities Select Sector SPDR from Jan. 15, 2015 to May 15, 2015.
During the past four months, the Energy Select Sector SPDR is leading the SPDR S&P 500 by 4.3% while the Utilities Select Sector SPDR is lagging the SPDR S&P 500 by 14.5%. Meanwhile, the Industrial Select Sector SPDR is trailing the SPDR S&P 500 by a modest 1.7%.
If energy and utility stocks keep their current trends for the next two months and industrial stocks rally to reverse their modest underperformance in the past four months, the relative returns of sectors would predict an interest rate hike after July 15.
Beyond July 15, investors looking for a leg up on the Fed's interest rate hike would do well to include the six-month relative returns of the energy, industrials, and utilities sectors among the indicators they use for tracking the Fed's move.
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