On Mar. 27, Federal Reserve Chair Janet Yellen spoke at a central bank conference about the “new normal of interest rate policy.”
The phrase “new normal” essentially refers to a near-zero Fed Funds target rate. Janet Yellen made some interesting comments about how the Fed is between a rock and a hard place when it comes to rate increases.
On the one hand, it is inevitable that rates will rise eventually. There are distortions in the bond market that need to be tamped down, and an artificial yield curve has made it difficult for financial firms to prosper like they should have during a normal recovery.
However, Janet Yellen also pointed out that raising rates could push inflation lower than it is currently. The Fed has been having trouble matching its long term inflation target of 2% over the last few years, and raising rates too quickly could make that even more difficult.
Assuming that the “message” Janet Yellen is sending to the market is that rates need to rise seems reasonable, but rates aren’t going to move very fast. Janet Yellen’s speech ended the short-term rally in bond yields, as you can see in the next chart of the 10-year Treasury yield.
10-year Treasury Bond Yield: Chart courtesy of eSignal
Let’s assume that the market is correctly interpreting the Fed’s intent and that it raises rates at a slower pace than originally assumed. How does this change the picture for sector rotation in 2015?
Lower Rates Could Stimulate Growth
Assuming all else remains equal, lower interest rates could continue to stimulate growth. Economic growth may continue to be slow, but asset prices could continue to rise without the threat of a major adjustment to the Fed’s balance sheet.
Growth tends to benefit small-cap stocks, technology and biotech disproportionately. Although there has been significant volatility over the last few weeks, the Russell 2000 small-cap index did break resistance and is currently treating that former level as support.
Trends will probably still be unclear until earnings begin to kick off later in April, but long positions in these sectors are likely to outperform if investor expectations for interest rates remain low.
iShares Russell 2000 ETF (IWM): Chart courtesy of eSignal
Delayed Rate Hikes Should Keep Income Stocks in the Lead
Dividend-payers have to compete with fixed income (bonds) for investment money. If bonds have low yields because the Fed keeps rates low, income investors have a much more significant incentive to buy dividend-paying stocks.
Therefore dividend-paying stocks can be hyper-sensitive to threats of rising rates because the average dividend yield is near a historical low.
The long-term average dividend yield among the stocks of the S&P 500 is almost 4.5%. However, it is currently a measly 1.92%, which wouldn’t be adequate compensation for the risk of owning a dividend-paying stock if interest on bonds was more attractive.
As you can see in the next chart, the SPDR S&P Dividend(ETF) (NYSEARCA:SDY) has been sitting at support and under pressure as expectations for higher rates began to accelerate last December.
SPDR S&P 500 Dividend ETF (SDY): Chart Courtesy of eSignal
Support for dividend-payers should push utilities, consumer staples and pass-through entities (like REITs) back into the lead in the second quarter of 2015. We have seen this kind of unusual rotation behavior happen before. The early 2013 and 2014 rallies were both led by income-payers as worries about higher interest rates eased.
Rates Will Still Rise
Janet Yellen may be setting expectations for a slow rise in interest rates, but we shouldn’t forget that that means the Fed will still raise them (at least a little) in the second half of 2015.
This will increase the interest rate differential between the U.S. and Europe, China and Japan. If the U.S. is raising rates, while the latter two economies are lowering rates or easing, the dollar will continue to look very attractive to international investors.
The dollar has already gained against global currencies considerably. However, that trend should continue as long as the threat of a rate hike remains credible. Unfortunately, this will probably contribute to weaker prices among companies that export products to the rest of the world.
A Rising Dollar Isn’t All Bad
In the short term, a rising dollar may actually help increase the profit margins for companies that are importing materials or goods into the U.S. For example, retail firms who buy products from China can buy more with stronger dollars (or buy the same amount with fewer dollars) to sell to consumers domestically.
From a rotation perspective, this means retail firms may continue to be the long-term winners. Over the last 10 years, no sector has done better on a total return basis than consumer discretionary stocks.
Investors looking for growth opportunities should favor that industry in the near term as the dollar supports profit margins. Gains here could offset potential losses among manufacturers and other exporters in the near term.
Conclusion
At this point, there is a significant percentage of finance professionals who haven’t been in the market during a rate hike. It has been a long time since that has happened, and it makes the eventual outcome much more difficult to predict.
However, we expect slower — or non-existent — rate hikes to benefit income-payers, small caps and retail firms directly or indirectly through 2015.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.
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