To Hike or Not To Hike: The Fed’s Big Decision

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This Wednesday, the Fed released its latest meeting minutes which give us a look into the their thinking on the state of the economy. Until recently, it had been assumed by most economists and analysts that the Fed would (finally) make its long-anticipated interest rate hike in this September’s upcoming meeting.

However, doubts have seeped in during recent days. First, China announced a surprise devaluation of their currency last week. While small in scale, the devaluation shows that the world economy is continuing to slow. Some are saying that China has fired the first shot in a “currency war”. Even if it’s nothing so serious, raising interest rates and applying contractionary pressure to the economy as China undermines the US’ economic position with a weaker currency could backfire.

Then, Wednesday morning, the government released new CPI inflation figures that showed inflation, contrary to expectations, had slowed substantially last month.

The Fed has a mandate to balance inflation and employment. It is supposed to encourage as much employment as possible without inflation overheating – generally a 2% inflation target is the standard. With inflation cooler than expected and below the Fed’s target, that gives it more room to delay, potentially, the rate hike until December.

And the release of the Fed minutes Wednesday showed that the Fed is wavering on whether to hike or not. One member of the Fed board is ready to hike immediately, but was willing to wait one more meeting. The Fed committee as a whole though found that “economic conditions warranting an increase in the target rate for the fed funds rate had not yet been met.”

Given that the economic momentum since that meeting which generated the minutes has been negative, I’d be surprised if the Fed sees enough evidence to feel compulsion to hike in September. So, it’d seem like the play now is to position ourselves for a no hike in September, high probability of a hike in December outcome.

For traders with a shorter-term outlook, the play here is to buy assets with high leverage to interest rate changes. Many of these sectors have already been generally beaten down in recent months, in expectations of a hike, and could enjoy healthy bounces following a Fed no-move in September.

In particular, I’m looking at REITs – such as the iShares U.S. Real Estate ETF (IYR). This fund owns a basket of real estate investment companies that make their profits borrowing at (hopefully) low interest rates and collecting rent that exceeds interest and leaves plenty for substantial shareholder dividends. Their business model works better with low interest rates. The ETF’s shares are down close to 10% since their 2015 peak, and now yield a healthy 3.6% annual dividend.

A more conservative way to play the trend is to take a look at utilities. Unlike REITs, these businesses are not so sensitive to interest rates. However, many yield-hungry investors own utilities as a bond-like substitute, since utilities tend to pay more interest than bonds nowadays but remain low risk. Since utilities are regulated businesses and customers will keep using electricity regardless of how the economy fares, these are extremely reliable businesses.

However, utility shares have fallen on concerns that rising interest rates will encourage investors to dump their utilities and buy bonds in their place. This selloff has cause shares of the Utilities Select Sector SPDR ETF (XLU) to be down close to 10% from the year’s peak as well. At present, the ETF yields a solid 3.4%.

Finally for investors seeking a more aggressive Fed play, one should consider the most beaten-down assets. Oil in particular is one place that could benefit substantially if the Fed remains on hold. Oil prices, down 60% now from last year’s peak, could rebound smartly once selling pressure abates.

While a Fed no-decision wouldn’t change the underlying dynamics for the commodity itself, the adding of more liquidity into the capital markets would encourage more risk-taking, and give more margin for speculators to try to find the bottom on oil. Particularly with bets against oil hitting extremes, the stage is set for a share reversal in the oil pits should the Fed ease up on its monetary policies in September.

Finally, foreign stocks – particularly in smaller emerging markets – would benefit from a Fed no hike. The US dollar has soared this year, causing routs of foreign currencies. This has led to panic selling of foreign shares and triggered rounds of austerity and belt-tightening across the developing world.

One way to play this would be in the iShares Latin America 40 ETF (ILF). Its shares are down from 45 to 25 over the past year, and are down 20% just this summer. This ETF would likely see a sharp rebound should the Fed not raise interest rates.

The next Fed interest rate decision will be announced September 17th. Stay tuned, there will be plenty of opportunities in the wake of their move.

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