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ETFs in Tug-of-War Ahead of March Fed Meeting

All eyes are on the two-day FOMC meeting slated to start today. Chances are that the Fed will raise interest rates for the third time in 10 years especially after the upbeat February job data. Per the latest CME Group poll, the odds for a rate hike shot up to 93% from 90.8% before the nonfarm payments report and just 25% in the beginning of February (read: Yellen Gives Hawkish Signals: 5 ETF Plays).

Upbeat Data

Activities in the U.S. have strengthened in the last few months as depicted by a series of economic data. The U.S. economy added 235,000 jobs in February, way above 200,000, as per economists surveyed by Bloomberg. The unemployment rate dropped to 4.7% from 4.8% in January while wages increased 2.8% from the year-ago period.

Meanwhile, inflation was off to a strong start this year with the consumer-price index recording its biggest monthly increase in almost five years in January. The index rose 2.5% year over year in January, above market expectations of 2.4% and was followed by 2.1% increase in December. With this, the economy is near full employment and inflation is on track to hit the 2% target, as per the Fed officials.

Further, consumer confidence rose to the highest level in 15 years in February as per the report from the New York-based Conference Board. Adding to the bullishness is Trump’s pro-growth policy that continues to boost the stock market (read: 7 ETFs Offering 20% Plus Returns Since Election).

While a 25 bps interest rate increase is widely expected in the meeting, investors are keenly waiting for the Fed’s guidance on the future rate trajectory. The latest poll also calls for two more 25 bps lift-offs in the second and fourth quarter this year, taking the federal funds target to 1.25–1.50 bps.

On the contrary, falling credit demand does not justify the March rate hike, as per seekingalpha. This is because demand for all types of loans including real estate and auto has been falling. This seems quite strange as Americans seek to lock in lower rates before an expected rate hike, a trend seen late last year before the December lift-off.  

Given this, several ETFs are in focus and could see outsized volume depending on the upcoming Fed decision. A few ETFs will continue to benefit if the Fed raises rates as expected or signals a hawkish outlook while a few will be severely impacted. Let’s have a look at them:

KRE vs. REM

While SPDR S&P Regional Banking ETF KRE will continue its stellar performance, iShares Mortgage Real Estate Capped ETF REM will be hit hard. This is because a rising rate scenario is highly profitable for the banks as these seek to borrow money at short-term rates and lend at long-term rates. Thus the steepening yield curve would expand net margins and bolster banks’ profits. On the other hand, mortgage REITs could be in more as short-term rates would rise faster than the long-term rates thereby leading to a tight spread and lower profits for mREIT companies.

KRE has a Zacks ETF Rank of 1 or ‘Strong Buy’ rating while REM has a Zacks ETF Rank of 4 or ‘Sell’ rating.

UUP vs. GLD

Rising interest rates will pull in more capital into the country and lead to appreciation of the U.S. dollar. PowerShares DB US Dollar Bullish Fund UUP is the prime beneficiary of a rising dollar as it offers exposure against a basket of six world currencies – euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc (read: Inside Dollar's Valuation: ETFs in Focus).

Gold will be hit hard as higher interest rates would diminish the yellow metal’s attractiveness since it does not pay interest like fixed-income assets. So, products tracking this bullion like SPDR Gold Trust ETF GLD will further lose (read: Time to Buy Gold ETFs on the Dip?).

Both the funds have a Zacks ETF Rank of 3 or ‘Hold’ rating.

HYG vs. STPP

As yield rises, bonds and related ETFs fall. While higher rates would fade the sole lure of the high-yield bond ETFs like iShares iBoxx $ High Yield Corporate Bond ETF HYG, iPath US Treasury Steepener ETN STPP directly capitalizes on rising interest rates and performs better when the yield curve is rising. HYG has a Zacks ETF Rank of 4 (read: Junk Bond ETFs in Troubled Space?).

EEM vs. DBEF

A rate hike would pull out more capital from the emerging markets, stirring up concerns for iShares MSCI Emerging Markets ETF EEM. On the other hand, the diverging policy in the U.S. and the rest of the world will result in huge demand for MSCI EAFE Hedged Equity ETF DBEF. Both the funds have a Zacks ETF Rank of 3.

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SPDR-GOLD TRUST (GLD): ETF Research Reports
 
ISHARS-EMG MKT (EEM): ETF Research Reports
 
ISHARS-IBX HYCB (HYG): ETF Research Reports
 
PWRSH-DB US$ BU (UUP): ETF Research Reports
 
IPATH-UST STEEP (STPP): ETF Research Reports
 
ISHARS-MTG RE (REM): ETF Research Reports
 
SPDR-KBW REG BK (KRE): ETF Research Reports
 
DEUTS-XT MS HDG (DBEF): ETF Research Reports
 
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