Federal Reserve governors will meet on Tuesday and Wednesday to review the state of the U.S. economy and whether to again raise the federal funds rate. This rate, charged to large banks for overnight loans, underpins all interest rates – from the 10-year Treasury to home mortgages. At its core, central bankers raise this key rate to incentivize consumer saving and slow down debt-driven growth.
Based on September’s meeting, there is a high probability that the federal funds rate will be increased. The market is heavily positioned toward this outcome with price action in the futures market pointing to a 97.2% likelihood that a 0.25% to 0.50% rate increase will be delivered. This metric from the CME Group has been wrong before and will be wrong again, but with the Dow printing record highs last week – the deck is stacked toward a rate increase on Wednesday.
Fed Funds and 10-year Treasury rates, 2006 to 2016
From an investment perspective, higher interest rates tend to make fixed income positions – like bonds and Treasury notes – more competitive relative to equity markets. Many gurus are looking for a significant interest rate increase to signal the end of this eight-year bull market that continues to push higher. Longer term, I think they are right. In the shorter term, consider these two stocks that should outperform during a period of rising rates.
American Equity Investment Life
American Equity Investment Life Holding Co. (AEL, Financial) is an insurance carrier that holds a diversified portfolio of annuity products. This business model performs well when rates increase for two reasons:
- When annuities are sold, the premium from these sales is invested into a basket of federal and corporate bonds – of which 99% are investment grade. When interest rates rise, the spread on these investments becomes more favorable for the carrier. This investment income is the largest component of American Equity’s revenue model.
- One of its core offerings, the fixed index annuity, becomes more competitive relative to stocks, bonds and ETFs as rates rise. These products offer a fixed return or equity-linked return (using the options market) which is financed by the firm’s investment portfolio. More revenue from federal and corporate bonds means a stronger equity-linked product offering to bring to the marketplace.
Deutsche Bank AG
Massive German lender Deutsche Bank AG (DB, Financial) has certainly had its share of bad press this year. Adding to these administrative failures has been a zero/negative interest rate environment within the European Union that has crippled the profitability of its corporate and investment banking units. Higher U.S. interest rates are likely to spur higher rates across the European Union, as these rates have historically been correlated.
Fed funds and long-term German bond yields, 1980 to 2016
Higher European rates mean a more profitable spread for Deutsche Bank's core lending activity. At $18 per share, Deutsche Bank is priced at just 12% of pre-2008 levels, is down 21% on the year and has significantly underperformed within the financial sector. It is worth consideration from a value investor’s perspective and represents a “buy the fear” opportunity.
Disclosure: I do not hold any positions mentioned in this article.
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