When Is the Right Time to Ride the Rate Hike?
- By Nicholas Kitonyi
The Federal Reserve is the most important central bank in the world. Prior to the announcement by Fed chair Janet Yellen on March 15, the probability of a 25-basis point rate hike was 95.2%. This figure was virtually a slam dunk for traders and investors seeking direct action from the Fed. The broader implications of a Fed rate hike are especially important. For starters, a 25-basis point hike in the region of 0.75% to 1.00% is a catalyst for a stronger U.S. dollar (USD).
Warning! GuruFocus has detected 5 Warning Sign with HENKY. Click here to check it out.
The intrinsic value of ARCA:SPY
When rates increase, demand for the greenback increases accordingly. Foreign currency is sold, and dollars are purchased. This has a significant effect on capital inflows. For example, capital (foreign direct investment) can go toward equities markets, commodities markets, investments (fixed-income yielding investments and treasuries) or held in cash. Currency traders who feel that the USD is on the ascendance will happily exchange euros, Japanese yen, British pounds and the South African rand for greenbacks. The point being, capital flows must be directed somewhere when interest rates rise.
Interest rates, lending and stocks
Typically, stock markets on Wall Street do not react favorably to rate hikes. The theory behind this is as follows: When interest rates rise, the cost of long-term loans and capital increases. In other words, companies listed on Wall Street will have to pay more to banks and financial institutions for the loans they've taken out. On the other hand, the markets would have already cultivated all the potential gains associated with rate hikes long before the announcement as noticed since the start of the year.
The chart below demonstrates how SPDR S&P 500 ETF (SPY) and the NASDAQ Premium Income and Growth Fund ETF (QQQX) trended during the period to the first rate hike of 2017 and after the rate hike.
When the real impact of a rate hike begins to affect the lending market, this decreases the profitability of listed companies and negatively affects share prices. The effects are even more adverse on a personal level in the sense that, unless a person has invested in the capital markets, there is no way of gaining from higher interest rates. As such, it is always advisable to consolidate debt prior to an interest rate hike to capitalize off the lower percentages while they are available. Fortunately, folks who fail to cash in on lower interest rates can take heart from the fact that there will be multiple Fed rate hikes in 2017, and there is still ample opportunity to consolidate credit card debt, mortgage debt, automobile debt and other loans prior to the next rate hike.
Nonetheless, for individuals who are looking to invest in equities, it's important to bear in mind that equities markets tend to cringe when rate hikes take place. This theory does not hold up in this instance because markets have priced in the possibility of a 25-basis point rate hike a long time ago.
The rate hike is minuscule by Fed standards, and the interest rate overall (the Federal Funds Rate) is at ultralow levels. Markets despise rate hikes, but they react even worse to the volatility of sharp and sudden interest rate hikes. But Yellen and her vice chair Stanley Fischer have consistently pushed the narrative of slow and steady rate hikes.
Gold and interest rates
For starters , gold is going to come under pressure. The gold price has been reeling in recent weeks, recovering somewhat just prior to the Fed announcement on March 15. The price of the yellow metal fell to $1,199.53 per ounce, down 0.20% or $2.37 following the rate hike announcement but has now recovered to trade at $1,256. This is nothing more than a typical rebound, and a decline is expected as we move closer to a potential second rate hike in 2017.
Gold is an interesting commodity to trade during rising interest rates. For starters, gold does not fare well during monetary tightening. The reason: Gold is not an interest-bearing commodity. In other words, there is nothing to be gained by holding on to gold while there is more to be gained from fixed-interest securities and Treasurys with rising interest rates.
Therefore, the yellow metal has long been a haven during financial crises. For now, investors looking to short the yellow metal would be more interested in trading gold than those looking for long positions.
Conclusion
There is a high expectation that the Federal Reserve will raise interest rates at least twice again this year. If the committee maintains the standard 0.25 points increment per hike, then that would take the U.S. base interest rate to 1.25% by the end of the year.
This will increase lending rates thereby adversely affecting floating interest loans for borrowers while boosting incomes of lending companies. As for the stock market, it is clear that the best time to capitalize on a rate hike comes months before the actual announcement.
Disclosure: No position in securities mentioned in this article.
Start a free seven-day trial of Premium Membership to GuruFocus.
This article first appeared on GuruFocus.
Warning! GuruFocus has detected 5 Warning Sign with HENKY. Click here to check it out.
The intrinsic value of ARCA:SPY
