Rising Rates Signals Stronger Economy
US Interest rates tend to rise and fall as the economy moves through its business cycles. The FED can influence the short-end more so than the long-end of the US yield curve. By lowering and raising the FED funds rates, the FED controls short-term maturities (i.e., 1, 2 years Treasury Bonds). The long-end of the US Treasury (i.e., 10-year and 30-year Treasury Bonds) comes from the longer-term trends of the US economy (i.e., inflation, recession, deflation, etc.).
For instance, an environment where interest rates (TNX and TYX yields) rise signals an improving economy and possibly an inflationary trend. On the other hand, if the economy slips into a recession or a deflationary trend begins, then TNX and TYX will likely decline (yields falling).
With the 10-year Treasury yield (TNX) exceeding 1% for the first time since March 2000, money is leaving the fixed income market and moving into the stock market. The steepening of the yield curve in hopes for more stimulus spending and a firmer economy favors a handful of sectors.
So, where are the investment opportunities that tend to benefit from higher rates and an improving economy?
Some sectors within the stock market are more sensitive to changes in interest rates than others.
The financial sector is one of the most sensitive to changes in interest rates. Financials benefit from higher interest rates and widening of the yield curve. Financial sub-industries such as money center and regional banks, brokerage, insurance, and asset managers stand to benefit through increased profit margins and higher net interest margins.
Brokerage firms and asset managers generate higher profits due to increased trading and investment activities when the economy improves and when rates move higher. Interest income also increases when rates move higher.
Banks rely on the spread (net interest margin) between what they pay clients (i.e., savings accounts and certificates of deposit) and what they can earn (i.e., US Treasuries).
Consumer Finance companies benefit when interest rates rise and when the economy strengthens or improves. Borrowers can make their loan payments, and lenders will have fewer non-performing assets.
Insurance providers fare well in higher interest rate environments because their underlying fixed-income assets (Bond investments) yield rises. Insurers tend to rely heavily on steady cash flows. They tend to hold many of their assets in safe and secure debt to back the insurance policies they write. An improving economy via rising interest rates leads to strong consumer confidence and strong consumer sentiments. Consumers will then purchase more cars and homes, which means more insurance policies are issued leading to higher profits for insurers.
Consumer Discretionary and Industrials
Financials are not the only outperformers in a rising rate environment or a healthy economy. Industrials and Consumer Discretionary are economically sensitive sectors that tend to benefit when the economy improves, reflected by higher interest rates.
Consumer Discretionary stocks are sensitive to economic conditions. Improving employment, a healthy housing market, and strong consumer confidence often leads to more spending on durable goods (cars, clothing apparel, appliances, luxury goods, furniture, hotels, entertainment, and leisure products).
The Industrials sector also benefits from a strong economy as infrastructure spending increases. Rising interest rates and an increase in housing starts tend to favor a select group of Industrials. Among the companies that benefit from this trend are construction related and indirectly transport industries.
10-year US Treasury Yield (TNX)
Attached is a brief analysis of the 10-year US Treasury Yield (TNX). The technical breakout above 0.957-0.975% (6/5/20 and 11/9/20 highs) on 1/6/21 confirms an ascending triangle and suggests higher yields. Near-term resistance is 1.173-1.21% (50% retracement from Dec 2019-Mar 2020 decline and the Nov 2019 downtrend). Intermediate-term resistance is 1.356% (61.8% retracement from Dec 2019-Mar 2020). A convincing move above this renders the next target to 1.429-1.487% (Feb 2020 breakdown, 38.2% retracement from Oct 2018-Mar 2020 decline, and the ascending triangle breakout projection). Initial support rises to 0.896% (50-day ma), and below this to 0.733% (200-day ma), and then 0.624% (bottom of the ascending triangle).
Relative Rotation Graph (RRG)
Relative Rotation Graph (RRG) chart shows the relative strength and momentum for the 11 S&P sectors. Remember, sectors with strong relative strength and momentum often appear in the Leading Quadrant (Green). As relative strength momentum weakens, they typically move counter-clock into the Weakening Quadrant (Yellow). When relative strength begins to weaken, it falls toward the Lagging Quadrant (Red). When momentum begins to improve again, it moves back up into the Improving Quadrant (Blue).
A review of the RRG in the eight weeks ending on January 4, 2021, suggests leadership currently concentrated within three S&P sectors (Financial (XLF), Industrials (XLI), and Communication Services (XLC)). Improving Quadrant shows two S&P 500 sectors (Energy (XLE) and Healthcare (XLV). The above RRG study further supports the basis for improving economic conditions and rising US interest rates resulting in outperformance from Financials, Industrials, and select Consumer Discretionary stocks.
SCTR ranking of Financial, Industrial and Consumer Discretionary
Enclosed is an SCTR study of the three sectors that are likely to benefit from rising interest rates and improving economic conditions. Each sector is ranked by SCTR from high to low.