After robust consumer spending data, which rose at an annual pace of 3.2% in the third quarter, the strong October employment report from the Bureau of Labor Statistics on Friday fueled the chances of an interest rate increase in this year’s final Fed meeting in December.
The report reflected a rise of 271,000 jobs (highest in 10 months) with the unemployment rate falling to a seven-year low of 5.0% from 5.1% the month before and appears headed towards carrying a 4-handle next month. While the data significantly beat economists’ expectations, it is expected to bring an end to near-zero rates since the 2008 financial crisis.
The Fed had previously rendered growth in the economy as “moderate” and hinted at a December rate increase if the economy remained on track. Though a strengthening dollar, lower business spending as well as slower U.S. gross domestic product growth in the third quarter cut short the hopes of a rate hike, slowdown in imports and the current healthy job data paint a better picture of the overall economy.
Why Finance Is a Good Bet
It is now time for investors to re-adjust their investment portfolios in order to benefit from the potential reversal of the interest rate environment. The finance sector, in this regard, seems to be a good bet, as several industries including insurance, banking, brokerage and asset managers tend to benefit from rising rates.
Banks derive benefits from a steep yield curve, i.e. when the spread between long-term and short-term rates is wide. The interest rates on deposits are usually tied to short-term rates while loans are often tied to long-term rates. This means that the potential rise in rates will enable the banks to charge more for loans, leading to an increase in the spread between lending rates and the rates paid on deposits.
Again, once the Fed finally decides to hike rates, the two major criteria – improving economy and inflation at 2% – must be satisfied. And both these scenarios also drive long-term interest rates. Moreover, an improving economy means that credit quality will likely improve, which will also aid banks’ profitability.
Insurance companies invest majority of the premium income received from policyholders in government and corporate bonds to earn investment income. They utilize this investment income in meeting their future commitments to policy holders. The potential rise in rates will allow the insurance firms to invest their new premium income in higher yielding securities, thereby leading to higher future returns. Â
With a rise in rates, brokerage firms are likely to engage in more investment activity. Brokerage firms earn interest income on un-invested cash in customer accounts. The rise in rates will allow the brokerage firms to invest at higher rates.
Further, asset managers can position themselves favorably with the rise in rates. In the fixed income sector, default rates are likely to decline and higher interest rates will enable reinvestment at higher yields, which ultimately will boost portfolio returns. The benefit can be achieved by positioning fixed income portfolios strategically through proper management of duration, diversification of sources of yield and maximize the reinvestment of income.
