As the spread of each variant of COVID-19 peaks, traders are becoming more concerned about tighter global monetary policy. The ECB and Federal Reserve, the Bank of England, and the Bank of Canada have already evaluated potential monetary policy tightening. As central banks begin to determine that higher inflation needs to be controlled, they could reduce their bond purchase programs and signal to raise interest rates.
The markets will likely be ahead of these central banks, which can be observed in the recent runup in the U.S. 10 year Treasury yields. Ten Treasury yields have increased 50 basis points from August to October, reflecting that the markets believe that the Fed will slowly begin to raise interest rates. As markets rates rise, interest-rate-sensitive stocks may start to underperform, while stocks that benefit from higher rates could likely outperform. Keep reading to see how to tailor your trading strategy to accommodate a tighter monetary policy.
What Happens to Stocks When Interest Rates Rise?
While not all companies underperform when interest rates begin to rise, many come under pressure. This phenomenon occurs because stock prices are valued based on the discounted cash flows of a company. Analysts will add up what a company is expected to make over the next couple of years and then discount that cash flow back using the current interest rates. As interest rates rise, the present value of those cash flows declines.
What Could Stocks Outperform When Rates are Rising?
Higher levels of interest rates tend to make discounted cash flows lower. It’s hard to make an argument that the market as a whole will rise when interest rates are rising. Some companies can make more money when interest rates are rising.
For example, banks can make more money when interest rates increase. Banks make money in several different ways. One of the ways they make money is to borrow from other banks at short-term rates and sell to consumers at long-term rates. A bank might borrow overnight from another bank every day and sell mortgages to customers that last for 30 years. If the 30 year mortgage rate is higher than the short-term rate the bank borrows, it will make money. If the spread between the overnight and 30 year mortgage rates is widening, then there is a chance that a financial institution’s profitability will increase. The financial sector has several ETFs that track the movements of banks, brokers, and decentralized financial providers.
Most stocks are interest-rate sensitive because they borrow from banks, and when interest rates rise, their costs rise. If they cannot pass these costs on to consumers, then these companies will be less profitable. Many stock sectors, including the technology and discretionary (cyclical) sectors, feel the pinch when interest rates rise.
More defensive sectors and ETFs could outperform growth sectors. Defensive sectors such as consumer staples can outperform during periods of rising interest rates. Consumer staples (like the XLP ETF) produce products like toothpaste, toilet paper, and canned goods, which can outperform because people need to buy these goods in goods times and bad times.
Why Do Central Banks Raise Rates?
You might wonder why a central bank would “take away the punch bowl” when things are going well. The issue is that during periods of growth, costs begin to rise in conjunction with wage gains. When consumers have more money because of higher wages, they are more likely to purchase discretionary items and pay a higher price. If prices rise at an accelerating rate, certain things will become too expensive. Many central banks have a target of what they consider a reasonable rate of inflation. The Federal Reserve has a target of 2% year over year. Currently, the inflation rate in the United States is 3.6%. While the Fed is more likely to tolerate higher inflation levels because of the pandemic, there will soon be a point at which they start reducing stimulus and eventually raise rates.
The Bottom Line
The upshot is that some sectors and ETFs could outperform the broader markets during the tighter monetary policy. Banks can generate gains by borrowing from each other over short periods and lending to consumers over long periods. This type of activity might offset some of the losses banks might incur from reducing demand for loans due to higher interest rates.
Most companies will experience lower profitability if demand declines in the face of tighter monetary policy. Additionally, the value of many companies and ETFs could decrease due to higher interest rates. Since stocks are valued by discounting future cash flows to the present using interest rates, higher levels of interest rates can generate lower values for stock and ETF prices. One of the best ways to manage risk against higher interest rates is to diversify your portfolio with staple companies that could outperform as interest rates rise.