While the market has started pricing in a June rate hike by the Federal Reserve, it’s still putting odds of the Fed actually raising rates at less than a third. This contrasts with the hawkish commentary from several Fed officials lately, however, which leaves me with the feeling that the Fed is trying to ready markets for a change. 

Merely the threat of a rate hike has forced a selloff in stocks over the last several years, and investors need to come to grips with the fact that the market may be underestimating the potential for higher rates sooner rather than later.

#-ad_banner-#A look at historical data and correlations to bond prices shows that in an environment of rising rates not all sectors are created equal, and some sectors may actually benefit from higher rates. Is your portfolio ready?

Will A Surprise Rate Hike Spell Disaster For Stocks?
Market expectations of a June hike have come up, but are still low despite evidence of a stronger economy and comments from Fed members. The CME Group FedWatch tool shows a market-based chance of just 28% for a June hike, up from 13% last month. While a June hike is still a 3-to-1 against, the market puts odds at 56% in favor of at least one rate hike by the July meeting.

Members of the Federal Reserve Board have been trying to talk market expectations higher recently so a sudden rate hike won’t come as a surprise for investors. Speaking at Harvard last week, even Chair Yellen sounded uncharacteristically hawkish saying that a rate hike in the coming months may be appropriate.

Minutes of the Fed’s March meeting showed some members wanted another rate hike as early as April, though others feared the message it would send to the markets. The Federal Open Market Committee (FOMC) noted that the economy was expanding at a modest pace and that inflation had picked up in recent months, satisfying both requirements for a rate increase. 

Fed officials have been firmly on the hawkish side lately, talking up the potential for rate hikes sooner rather than later. Philly Fed Bank President Patrick Harper called a June hike ‘appropriate’ unless data weakens. 

Economic data seems to point to a strong rebound in the second quarter, with April durable goods surging on transportation and jobless claims coming in better than expected. All the signs are there to a surprise rate hike when the group meets June 14 and 15. 

Who’s At Risk And Who Benefits From Rising Rates?
Research across 15 ETFs representing stock sectors, bonds and real estate presents some interesting winners and losers against rising rates. Funds were compared against the iShares 20+ Year Treasury Bond ETF (NYSE: TLT). As with bond prices, the price of the treasury fund moves in opposite directions to rates. If rates were to increase quickly, the treasury bond fund could plunge.

The correlation between each fund and the treasury fund on the x-axis ranges from negatively correlated as with the financials fund at -0.56 to a slight positive correlation in the iShares 1-3 Year Bond Fund (NYSE: CSJ). Shorter-term bonds are less affected by rising rates because they have less time until maturity and they don’t have to compete against newer, higher-rate bonds for as long. Assets and sectors negatively correlated with the bond fund means prices tend to increase as rates rise while those that move with the bond fund would see prices fall with a rate hike.

Funds With Highest Negative Correlations:
•    Financials Select Sector SPDR (NYSE: XLF) 
•    Industrial Select Sector SPDR (NYSE: XLI)

Non-Bond Funds Most Closely Correlated With Bonds:
•    Utilities Select Sector SPDR (NYSE: XLU)
•    iShares Mortgage Real Estate Capped (NYSE: REM)

The Treasury fund lost 9.7% over the month to May 19, 2015 for its worst monthly performance in five years as fear of a rate hike mounted. The y-axis charts each fund’s performance during the same month, ranging from a gain of 3.1% on the Financials ETF to -3.2% on the energy fund. While falling energy prices affected the energy fund, both the real estate funds saw sharp drops on the month as investors worried about higher borrowing costs for property.

Funds With Best Performance When Bond Prices Plunged:
•    Financials Select Sector SPDR 
•    Technology Select Sector SPDR (NYSE: XLK)

Funds With Worst Performance When Bond Prices Plunged:
•    Energy Select Sector SPDR (NYSE: XLE)
•    Vanguard REIT ETF (NYSE: VNQ)

The size of the bubbles represents the year-to-date gain in each fund, ranging from a gain of 12.5% on the energy ETF to a gain of just 0.4% on the iShares Floating Rate Bond ETF (NYSE: FLOT). Utilities and real estate have both done well this year as market expectations for higher rates came down, but could be the hardest hit as those rate fears return. 

Most at risk as rates increase will be bond products, real estate and utilities. Shorter duration bonds with maturities of less than five years may not be hit as hard but will still see prices fall. Even floating rate bonds which are partially protected from rising rates may be at risk. The utilities sector fund has jumped more than 12% so far this year but could weaken quickly if rates hikes come faster than anticipated and even real estate could drop on fears of higher borrowing costs.

Financials, technology and healthcare may outperform as rates increase in the near future. All three are negatively correlated with the bond fund, meaning prices tend to increase when bond prices decrease. All three fund saw their share price increase more than 1.75% when bond prices were shocked lower in May of 2015 and year-to-date gains are relatively low compared to some of the runaway sectors so far this year. 

There are fundamental factors backing the three sectors as well. Rates generally rise when the economy is growing which usually means more borrowing and investing by consumers. Combine that with a larger interest spread on the bank’s lending and you get higher profits at financial institutions. Increased spending by businesses and consumers when the economy grows is also a good sign for technology companies. For its part, healthcare spending is relatively stable when rates are heading in either direction and should do well on the continued aging of the population.

Risks To Consider: While the historical data bears out relationships with rates, external circumstances may cause a sector or asset to perform differently this time around.

Action To Take: Take a position in sectors like financials, technology and healthcare that may do well on a rate increase while cutting exposure to bonds, utilities and real estate.

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