How Will the Fed’s Hawkish Stance Affect the Financial Sector?

How Will the Fed’s Hawkish Stance Affect the Financial Sector?

The US inflation has dropped by nearly 70% after setting an all-time high of 9.1% last June 2022. But recently, consumer sentiment has soured as it rebounded and exceeded the 3.6% consensus. The ongoing Russo-Ukrainian and Israel-Palestine Wars are further aggravating the situation.

OPEC+ supply cut concerns have resurfaced, pushing Brent and WTI oil prices upward. It may become even more problematic this quarter as the holiday season approaches.

These events may prompt the Fed to resume policy tightening to mitigate inflation and protect its currency in its November meeting. While it will lead to higher yields for banks and other lending institutions, the risk of defaults and delinquencies may follow.

As such, the financial sector becomes more exposed to risks as their recent growth trend appears toppish. This article will help investors and consumers look into the real estate and financial sectors as rate hike woes seep into every household.

Real Estate

The real estate market has been one of the inflationary drivers in the past two years. Demand influx remains the primary market force that dictates the price and value of properties. Although sales prices have slowed in the first half of FY23, they remain much higher than pre-pandemic levels.

At $416,100, the median sales price is 13% lower than the FY22 peak but over 20% higher than the 2019 peak. Despite this, residential housing shortages remain high, ranging from 5.5 to 6.8 million units.

Given this, home prices will not be impacted solely by the potential policy tightening. There is a complicated mix of drivers, such as demand, shortages, property building timelines, and wages. However, rate hikes may be challenging for buyers and sellers since they may face steeper mortgage payments. In short, higher interest rates will raise mortgage rates and lower demand. Nonetheless, it will not lead to a bubble burst as shortages remain high.

Banking

Banks are susceptible to macroeconomic changes since their primary operations involve loans, deposits, and investments. In the past three years, they have enjoyed the influx of borrowers and investors as interest rates reached near-zero levels.

But their recent growth has turned precarious, hinting at potential future declines. Some banks still show promise in sustaining growth, especially those with low Loan-to-Deposit and Non-Performing Loan Ratios.

Higher interest rates can become a double-edged sword for most banks. Banks will see higher loan yields and deposit inflows, leading to higher interest income and liquidity. However, they must account for loan default and delinquency risks, higher credit provisions, and higher interest expense.

They must be careful with their loan diversification and focus on more interest-sensitive yet more secure loans like corporate loans. Doing so can help them offset the impact of deposit yields and provisions that may squeeze their margins.

While they have a higher sensitivity to macroeconomic volatility, many off-the-radar banking stocks remain promising. TFS Financial Corporation (TFS) is a perfect example, with its stock price upside potential and enticing dividend yield of 9.66%. Also, about 80% of its shares are under MHC, a federally chartered mutual holding company.

Other Lending Institutions

Aside from banks and mortgage lenders, other institutions like payday lenders must prepare for a potential policy rate hike in November. Like banks, they will see higher interest on their loans. However, they have a higher risk exposure since loans are often uncollateralized. Also, payday lending is subject to greater scrutiny due to borrower harassment issues.

Meanwhile, student lending centers are less sensitive to Fed rate changes since Congress considers student loan rates fixed from the first of July of the current year to June 30 of the following year. So, regardless of their credit score and income, all students shoulder the same interest rate.

They can also turn to institutions offering refinancing student loans like SoFi to help them with their monthly payments. Hence, the impact of the potential rate hike will materialize on July 2, 2024.

Insurance

Insurance companies are also sensitive to interest rate changes since they invest in interest-sensitive assets like bonds. Given the current macroeconomic environment, many investors and brokers prefer a conservative approach.

Higher interest rates may disrupt their investment strategies and squeeze their profitability. Remember that existing bond prices tend to decrease when interest rates increase. On a lighter note, higher interest rates can make products more attractive since they raise future obligations to policyholders, leading to higher premiums.

For P&C insurance, other factors like the real estate market performance are involved. So, if the policy tightening reduces property demand, P&C insurance will see a similar trend. Even so, the situation is different for states along the Atlantic coastline due to their higher hurricane exposure.

Investment Holdings

The impact of interest rate depends on the type of asset or investment traded in the market. Generally, higher interest rates lead to a lower value of bonds and stocks. Lower prices may lead to lower market inflows. For the last three months, Dow Jones (DJIA), S&P 500 (SPX), and NASDAQ Composite (GIDS) have had negative returns of -4.4%, -5.5%, and -7.0%.

Conversely, the Forex market is more attractive as the US Dollar maintains its strength relative to other currencies. Its relative value to the Euro, Pound, and Yen remains much better. Currently, thanks to the impeccable US Treasury yields and relatively lower inflation, the USD may continue to appreciate with higher interest rates.

Bottom Line

Interest rate changes are a double-edged sword for the financial and property markets. They lead to higher yields but raise risks. This is the main concern for investors wishing to diversify their assets across these industries in a risky macroeconomic landscape. But overall, the US economy remains stable relative to 2022 if we exclude the effect of external factors like oil. Even better, all sectors show strong resilience against the potential blows of higher interest.