The impact that interest rates can have on the market is more complicated than the binary view of higher rates = low growth, lower rates = high growth. Yes, there are some sectors that suffer from higher interest rates, and the market averages may seem to have a negative correlation with interest rates, but that isn’t always true across the board.
While we are in between earnings seasons, we thought this would be a good opportunity to dig into an example of the multi-faceted problem of interest rates and where we are looking for opportunities in the near term.
Over the last couple of decades, interest rates have had a positive correlation with stock returns. This wasn’t always the case, but, since quantitative easing became the policy tool of choice for the Fed in the early 2000s, these two asset classes have been positively correlated overall.
Because the focus on short-term interest rates has become so extreme over the last few years, it’s easy to miss the “yield forest” for the trees.
For example, property and casualty (P&C) insurance companies will sometimes feel different effects from rising interest rates. And their reaction will differ further from life insurance companies. There are a couple of reasons for this.
First, P&C companies manage large financial portfolios that are designed to be fairly conservative so that they will have money available to cover claims, which means they have a very heavy weighting to short-term Treasury bills.
The problem for P&C insurance companies is that they are also very sensitive to asset inflation, which can create a mismatch between the returns on their financial assets and their potential liabilities from claims.
For example, assume that a company has an insurance policy on their building that is appreciating with the real estate market. The “inflation” of the building as an asset could (and probably has) outpaced rising yields on new additions to a P&C company’s portfolio. Further, the current bonds in that portfolio are at risk of declining if the Fed raises interest rates.
In order to immunize themselves from these risks, P&C companies have to be a lot more active and take more risk in their portfolio than they would otherwise — which drives costs.
The second issue that P&C companies face is exposure to the underwriting cycle during periods of economic growth. The underwriting cycle describes the increased competition among insurance companies when the economy is growing and businesses need more insurance. Like the gold boom of the 2000s did to gold miners, the underwriting cycle winds up putting pressure on P&C margins despite the rising demand for their products and coverage.
Most of the large P&C companies here in the U.S. have done a good job navigating these two issues over the last few years. For example, Allstate Corp (NYSE:ALL) has been so competitively dominant that it has been able to use its excess cash to essentially buy 20% of its stock back from the market since 2010.
For many of these firms, low asset returns and the underwriting cycle have been outpaced by growth. However, all things in the market are cyclical, and P&C companies have drifted from outperforming the S&P 500 to underperforming this year.
This may actually present some interesting opportunities. As you can see in the next chart, as interest rates (as measured by the 10-year Treasury bond yield) have risen, P&C companies like Travelers Companies Inc (NYSE:TRV) and Allstate declined as their portfolios suffered. Once bond yields began to flatten out, ALL began to rise again.
This relationship with interest rates has sunk a number of these firms into a channel, with a resistance level that will be tough to beat without a shift in the fundamental environment.
Over the long run, rising rates will probably help the bottom line, but, in the short term, this can be a real opportunity for short-term bearish trades if rates rise.
However, P&C companies have an advantage over their life-insurance peers. Rising rates may be bad for P&C in the near term, but life insurance companies tend to suffer more because they hold longer-term bonds and can’t raise rates on existing policy holders.
From a strategy perspective, this could create three different trading opportunities in the next several weeks.
- If rates continue to rise, P&C and life insurers should both fall back towards (or even below support) as the underwriting cycle compounds the losses in their portfolio holdings.
- If the Fed is particularly dovish in June and rates start to fall back towards support, P&C companies could easily rally back through short-term resistance and towards their highs from January.
- In either scenario, life insurers are probably the weaker group within the sector. Falling short-term rates risk higher inflation, which will hurt them more. For the same reason, rising short-term rates will probably be multiplied in the long-term side of the yield curve, which hurts their holdings the most. An investor could pair a short position in an underperforming life insurer with a long position in a P&C firm assuming that the spread between the two in a rising or falling market will continue to provide profits.
The interest-rate problem is not always as straight forward for traders as it seems from the typical headline. There are a lot of moving parts, but that also means that there is the potential for more opportunity as well. Over the next few weeks, there will be a number of developments in the interest-rate environment that we as traders will watch for the opportunity to make some profits.
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.
You can learn more about identifying price patterns — like a bearish head and shoulders top — and using them to project how far you think a stock is going to move in their Advanced Technical Analysis Program.
