There are a variety of reasons why the S&P 500 has been mired in a narrow 5% trading range over the past month, including uncertainty about the pace of the recovery, inflation, and maybe even turmoil in the bitcoin market.
But surely a key driver has been the 10-year Treasury yield, which has been locked in a 13bps range as bond markets take a more measured view of inflation risks and the Fed’s apparent willingness to focus on transient factors.
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Summary
- Equities and bond markets have been range-bound and quiescent for weeks now.
- But investors may not fully appreciate how much interest sensitive sectors have fluctuated sharply as the 10-year Treasury moves to the high and low end of its range.
- The technology and utilities sectors will likely sell off if rates rise, and rally if rates fall. Financials should struggle in either scenario.
- Investors with firm views about the next major move in rates should position themselves accordingly.
Market Implications
- For rising rates, be long the S&P 500 via the SPY ETF, and short technology (XLK) and utilities (XLU), or the opposite for falling rates. We suggest being short financials (XLF) in either scenario.
- When will that move come? Maybe as soon as today after the labour market report. Or perhaps not for weeks or more.
There are a variety of reasons why the S&P 500 has been mired in a narrow 5% trading range over the past month, including uncertainty about the pace of the recovery, inflation, and maybe even turmoil in the bitcoin market.
But surely a key driver has been the 10-year Treasury yield, which has been locked in a 13bps range as bond markets take a more measured view of inflation risks and the Fed’s apparent willingness to focus on transient factors.
Turmoil Beneath the Surface
While the broad equity and bond markets have been quiescent there has been more action at the sector level (Table 1). In this note we focus on equity sectors that have been particularly rate sensitive – in particular – Financials, Real Estate, Technology and Utilities (represented as ETFs by XLF, XLRE, XLK, and XLU, respectively).
One thing that stands out about all these sectors is how jumpy they have been as the 10-year Treasury yield approaches 1.7%, and how they have rallied as the yield drops to 1.6% (Chart 1).
We expect this directional volatility will continue as long as the 10-year Treasury yield remains in this range. That said, it will be difficult to trade this pattern given the ongoing risk that some catalyst will send the 10-year yield out of this range.
Rate Sensitive Equities Will Track Treasuries
When this happens, look for these sectors to respond strongly. If rates rise, a selloff is inevitable for financials, technology and utilities. Higher rates will diminish the growth lustre of technology. In our view banks face major headwinds as long as the Fed continues its QE program. The primary lure of utilities in a low rate environment is a dividend yield around 3% but that becomes less attractive as rates rise.
Should rates fall, technology and utilities will benefit. Banks and financials come under pressure, again because of ongoing headwinds.
The real estate sector, which is largely REITs, is more defensive. It should rally if rates falls, but it may outperform other rate-sensitive sectors if rates rise given the strong housing market.
Investors who have strong views about the next major move in rates should position themselves accordingly. For those concerned about rising rates, we suggest being long SPY and short financials, technology and utilities. This can be done by selling ETFs short, or by buying an inverse ETF.[1] For investors who anticipate falling rates we suggest the opposite trade.
For investors who don’t have a strong view we suggest staying on the sidelines. If/when the move happens, they will miss the initial move. But it will likely continue to be a momentum trade as long as rates are moving higher or lower.
What Will the Catalyst Be?
For our part we think the next major move in rates is higher. However, we acknowledge that rates could fall if the recovery slows or the labour market remains sluggish.
The other big question is what the catalyst might be to move rates and when might it happen? We can’t say. It could be as soon as today, after the labour market report. Or it might not happen for weeks or more.
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Inverse ETFs use equity derivatives that move in the opposite direction of a normal long position. For more information about sector inverse ETFs, check www.etf.com . ↑