The Dow and S&P 500 indices sold off heavily earlier this week for a strange reason. The yield on the ten-year US Treasury broke above the 3% level.
Investors have been casting a wary eye on the 3% interest rate level for a while now.
The billionaire bond manager Jeff Gundlach warned months ago that, if the yield rises above 3%, then the rising interest rate trend could accelerate. Other market observers think the same thing.
As a result, for investors the three percent level on the ten-year has become a psychological “line in the sand” in terms of market danger. But why?
It’s not so much a specific level but the trend of rising rates. As interest rates climb higher from historically low levels, it can hurt the stock market.
When interest rates rise, borrowing costs rise too. That makes it harder for companies to do share buybacks and pay attractive dividend yields. It also increases “debt service cost,” the payments companies make on their existing debts.
The corporate bond market is also vulnerable. There is roughly $3 trillion worth of US corporate bonds that have a credit rating that is investment grade but only a notch or two above “junk.” If rates rise too high, a big chunk of those bonds could fall to a “junk” rating, which would create a big sell-off in corporate debt markets (as many institutional bond buyers aren’t allowed to hold junk).
Consumer spending is vulnerable too because rising interest rates mean higher mortgage and credit card rates, which can cut into consumer spending.
And the pain doesn’t stop there. Vulnerable industries that rely on low-cost debt could be hard hit. American farmers in particular are in danger after years of low prices for their crops.
The US farming industry has doubled its borrowing levels from around $200 billion circa year 2000 to almost $400 billion today. Rising interest rates could put many farmers out of business and hurt many other industries where profit margins are low and borrowing levels are high.
Rising interest rates could also be a negative for emerging markets, again because of all the debt that gets more expensive. In China, for example, there is a private debt bubble of close to $7 trillion with almost 60% of that tied to mortgages. China has a major housing bubble that hasn’t popped yet. If interest rates rise globally, with US bond markets leading the way, that could help pop it.
So, it’s no real surprise that investors are worried. They see interest rates going up, and they fret that rates will continue to rise or even begin to rise faster from here.
The Federal Reserve, meanwhile, isn’t worried about causing pain by hiking interest rates. They are more worried about the potential dangers of inflation as the US economy heats up.
In the United States, labor markets are tight. Jobless claims (the reported number of unemployed workers, a measure of tightness in the job market) are at their lowest levels since 1969. The Fed pays close attention to data points like this.
There are numerous areas of the market that could be hit hard if interest rates keep rising or if investor fear of rising rates start to intensify. Emerging markets and commodity-related industries are two big ones. China and other emerging market countries are vulnerable to a global rate rise led by the USA. Pain here could in turn hit commodity prices.
For a place to find shelter against rising interest rates, consider regional investment banks.
Regional investment banks do most of their lending locally rather than internationally, so they don’t have as much exposure to vulnerable emerging markets.
And regional investment banks are also seeing a positive bottom line benefit from rising rates, through the ability to earn a higher profit on their lending spreads. As a bonus, because of their domestic focus, regional investment banks aren’t as exposed to other international worry factors (like trade war).
One simple way to gain exposure to regional investment banks is through KRE, the SPDR S&P Regional Banking ETF. As you can see from the chart below, KRE remains in the green zone and has an overall positive trend.
We wouldn’t be surprised to see more capital flow into KRE, and into regional investment banks generally, if rising interest rate fears persist. Many industries have negative exposure to the rising rate trend, but for regional banks it’s a positive.
Richard Smith, PhD
CEO & Founder, TradeStops