XLU: This Sector Is Unhappy About Higher Rates

By | December 3, 2015

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The Federal Reserve is expected to raise its benchmark lending rate in coming months. Utilities stocks have thus trended lower due to their bond-like qualities, and dependence on debt financing. As the Fed tightens its policy, XLU presents an attractive short opportunity. While the stock market as a whole may not correct due to the U.S. rate increase, Utilities Select Sector SPDR (NYSEARCA: XLU ) will likely show weakness. The utilities sector is heavily dependent on interest rates for two reasons. First, utilities use a lot of debt financing to run its operations. This means that when interest rates rise, their debt servicing costs increase, and thus weigh on bottom line growth. Another factor is that utilities companies are generally slow growing, and thus return earnings to shareholders in the form of a dividend to attract investment. This aspect gives utilities stocks, as well as the broader XLU a bond-like asset quality. Therefore, when interest rates rise, share prices of utilities stocks decline. The chart below shows the correlation between the U.S. 10-year Treasury yield compared to XLU over the last five years. As the Federal Reserve began slashing its lending rate as a result of the financial crisis, the 10-year yield fell from over 3.6%, to a bottom of 1.375%. This drastic decline was the catalyst for a sharp move higher in XLU, as well as broader U.S. equity markets. When the Fed made it evident in 2013 that it was planning on ending its stimulus measures, interest rates rose, while XLU consolidated tightly, but then utilities resumed their uptrend as an actual rate hike was found to be years away. Now, however, as markets prepare for an actual U.S. lending rate, XLU is experiencing volatility again, and has underperformed the broader market throughout 2015. With the Fed likely hiking rates over the next few months, utilities companies, such as– NextEra Energy (NYSE: NEE ), Duke Energy (NYSE: DUK ), Dominion Resources (NYSE: D ), Southern (NYSE: SO ), and American Electric Power (NYSE: AEP )-have all begun to trend lower. Their operating environment looks to become more challenging amid higher rates, while investors find the sector’s dividends less attractive relative to higher prevailing interest rates. For this reason, XLU and its component companies look to be interesting short opportunities in coming months as the Fed tightens policy measures. (click to enlarge) Scalper1 News

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