Originally posted at Briefing.com
Interest rates moving up are either a good thing for the equity market (generally speaking) or a bad thing for the equity market (generally speaking). The distinction revolves around why interest rates are going up and the pace at which they are going up.
If you want to get a sense of what the market is thinking about the implications of rising interest rates, look no further than the financial sector and specifically the regional bank stocks.
A Drop and a Pop
Market rates were pushed to historically low levels for a variety of factors, none more prominent than the Federal Reserve's designed suppression of long-term interest rates through its purchases of Treasury securities.
Other factors contributing to the drop in rates have included the following:
- An investor flight to safety in the wake of the financial crisis and stock market crash
- Pension funds rotating into bonds in a bid to protect material gains achieved in the bull market run for equities off the 2009 lows
- Baby Boomers shifting to favor income investing to ensure a return of capital in retirement years
- Interest rate differentials and weaker foreign currencies that have sparked inflows from foreign investors
- New regulations that have boosted liquidity requirements for banks, which many have attempted to meet with the purchase of Treasury securities
- A declining rate of inflation (and fear of deflation)
- The fear of another stock market meltdown/financial crisis triggered by the ill effects of major central banks holding policy rates too low for too long
Market rates have been moving higher of late and in dramatic fashion at times. That movement has caught everyone's attention from investors in emerging markets to mortgage bankers on Main Street.
It has happened at a time when the probability of Greece defaulting on its debt and possibly exiting the eurozone has increased and when market participants have learned that first quarter GDP in the US contracted 0.7%. In other words, it has happened at a time when some investors might have least expected it given the US Treasury market's moniker of being a safe haven and an opportune place to park money when growth is weak and inflation is low.
What this action means is open for debate and revolves around two schools of thought:
- The jump in rates reflects the market's assumption that economic growth and inflation are poised to accelerate, thereby inviting the first rate hike from the Federal Reserve since June 2006, or
- The jump in rates is simply a function of air being let out of an overvalued market that has been crowded with the same thinking that rates will stay near historically low levels for some time due in part to demographics, weak economies abroad, and the US economy continuing to grow below its potential
Right Time, Right Place
The arguments behind both schools of thought are not without reason. The first argument, however, implies the move higher in rates is the start of a new trend consistent with a strengthening economy, whereas, the second argument implies it is a pocket of weakness that will soon get bought.
It's a move that is admittedly tough to decipher at this time knowing the economic data have yet to corroborate the acceleration argument in a convincing fashion and knowing that a spike in rates in 2013 turned into a big buying opportunity that took the yield on the 10-yr note from 3.00% to 1.65% earlier this year.
[Hear: Robert Johnson on His New Book – Invest With The Fed]
The economic data will ultimately clear up any confusion, but what we can surmise at this time is that stock market participants are favoring the acceleration view.
We can determine as much looking at the performance of the financial sector and the regional bank stocks. They started the year in very poor fashion, but note in the charts below that they turned higher at nearly the exact time the yield on the 10-yr Treasury note hit its low for the year on January 30.
These are the areas that one wants to see leading at a time like this. Their leadership connotes a sense that interest rates are going up for the right reasons (i.e., on the back of improving economic activity that should translate into improved earnings growth) as opposed to psychological reasons tied up in exiting a crowded trade or worrisome reasons like stagflation taking root.
To this point, rising interest rates typically go hand-in-hand with an improving economy. While higher rates eventually slow both economic and earnings growth, that doesn't happen instantaneously when the economic forces driving rising interest rates include increased employment, wage growth, and a pickup in consumer and business spending, which are all part of the market's hopeful economic equation right now.
Some of that optimism can be seen in the steepening yield curve, which still isn't nearly as steep as it was this time last year, but is nonetheless behaving in a manner of late that is beneficial to the banks and consistent with the idea that economic growth appears poised to accelerate.
What It All Means
Higher interest rates should benefit a variety of companies in the financial sector. That's why the financial sector has been acting so well of late.
Banks should see their net interest margins expand and profitability improve since their lending rates and the interest rates on their investments will go up at a quicker pace than the rates they pay depositors.
We think the regional bank stocks are the key stocks to watch in this area with respect to the US recovery argument. Regional banks are in a prime position to capitalize on an uptick in US economic activity since they are domestically-oriented and will undoubtedly see increased borrowing demand and more banking activity as a result of stronger US growth.
If the regional bank stocks aren't doing well, then there will be room to question the US recovery argument.
[See: Corporate Cash Piles Up]
There is room still to do that now based on incoming economic data, yet the outperformance of the SPDR S&P Regional Banking ETF (KRE), which is up 21% since the end of January versus a 3.0% gain for the S&P 500, reflects a market that thinks this time is different with respect to the idea the US economy will rev up convincingly in the back half of the year and maintain that recovery momentum.
In a broader sense, the financial sector, through its capacity to lend, to insure, and to manage a growing base of assets, is in the sweet spot to benefit from a rising interest rate environment that is the product of stronger growth.
One can bank on the regional bank stocks though as being a signpost for where the market thinks the US economy is headed and whether rising rates are indicative of being a blessing or a curse for the equity market.
