Reinforcing A Favored Rising Rates Trade

It is a simple scenario: Financial services exchange traded funds have been among the fourth quarter's best-performing sector ETFs because many investors believe this will be the month in which the Federal Reserve hikes interest rates for the first time in nine years.

Bolstering the case for ETFs such as the Financial Select Sector SPDR (NYSE:XLF), the largest financial services ETF by assets, is the fact that many market observers believe the Fed will boost borrowing costs several times next year, sending the benchmark U.S. lending rate to 1.25 percent by the end of 2016.

As hasbeen widely noted in the run-up to the Fed's December meeting, regional bank stocks and ETFs, such as the SPDR S&P Regional Banking ETF (NYSE:KRE), are seen as prime beneficiaries of higher interest rates. Simply put, net interest margins at regional banks have been suppressed by the Fed's zero interest rate policy and reversing that policy is seen as an important catalyst in boosting profits for the banks in ETFs such as KRE.

"The financial sector is one of our preferred equity market segments in a rising rate environment because their returns have shown the most positive relationship to interest rate movements, as measured by the beta sensitivity to the 10 Year Treasury Yield, over the last 36 months," said State Street Global Advisors Vice President David Mazza in a recent note. "To more precisely harness the effects of rising rates, investors should consider the SPDR S&PRegional Banking ETF [KRE]. KRE exhibits a strong positive relationship to ratesmore so than the broader financial sector."

In the essence of precision, KRE's positive correlation to rising Treasury yields is nearly double that of XLF's and more than quadruple of that S&P 500.

Higher interest rates are seen as boons for regional banks' net interest margins, a key measure of profitability for these banks. This is how sensitive KRE is to rising rates. From February 2 through June 10, 10-year yields climbed 80 basis points, contributing to a gain of almost 19 percent for the regional bank ETF over that span.

History shows investors may not want to wait to get involved with regional banks and KRE. Perhaps that is why the ETF has seen fourth-quarter inflows of $167 million on its way to a gain of over 5 percent.

"The early part of the tightening cycle is especially constructive for banks, as higher rates create more room to increase margins on their loans without stifling demand. For regional banks, mortgage financing is a primary business, and we expect demand for mortgages to increase as home prices rise and Americans head to their local bank to borrow money to buy a house. Regional banks also engage in commercial lending, and an improving economy will entice businesses to increase their borrowing to finance growth and investments," adds Mazza.

Disclosure: The author owns shares of XLF.

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