Utilities in Focus as Market Contemplates Fed's Rate-Hike Plans


Re-Tweet
Share on Facebook
Share on Google+
Share on LinkedIn

The Federal Reserve announced its long-anticipated interest rate hike on Wednesday. While markets attempt to deduce how quickly rates will rise, interest rate-sensitive stocks, like those in the utilities sector, saw a jump in their implied volatility.

As was almost universally expected, the Federal Reserve announced Wednesday that it was raising its key interest rate by a quarter-point to a new range of 0.5%-0.75%.  This was only the second time in a decade that the Fed has raised rates.

Going into the rate decision, the options market was pricing in a 90.7% chance that the Fed would increase rates by a quarter point, according to the CME's FedWatch tool.  These odds were actually down slightly from last week, but still in the area of near-certainty.

But while Wednesday's rate hike was well telegraphed, the outlook for the rest of 2017 is more uncertain.  For its part, the Fed's "dot plots" now predict three rate hikes in 2017.  This is one more than previously estimated.

The Fed's next interest rate announcement is expected on February 1.  The market currently sees very little chance of a rate hike at that time.

The FedWatch tool is currently projecting just a 6% chance of a further hike in February (and no chance that any hike would be more than another quarter point).

Looking further out, the Fed will have another policy announcement on March 15 and then again on May 3.  Currently, the consensus among market participants points to a nearly 27% chance of a rate hike by March (with a very thin chance that rates will be half a percentage point higher by the end of that meeting).  By the May meeting, the odds are sitting at about 40% for a further hike by then.

According to the markets, another rate hike doesn't become likely until the June 14 meeting, when there is a better than 75% chance of further hikes by the end of that meeting.

By the end of the year, trading indicates that the most likely scenario is that that rates will be half a point higher.  There is a better than 60 percent chance that rates will be either 50 or 75 basis points higher by the end of the December 13 meeting.

Performance in utility stocks are considered strongly tied to interest rates.  This is because one of the main draws of the sector for investors is the high dividends often offered in the segment.  Implied volatility advanced for most of the major sectors on Wednesday (technology was the only exception), with utilities leading the way.  Implied volatility for XLU, the SPDR Utilities ETF, was up 8.6% on the day. 

XLU's implied volatility made stutter steps higher from August into November, as expectation of a rate hike grew.  It reached 21.1 on November 10, its highest close since mid-February.  It came off that mark from there, and remains off its 2016 high, even with Wednesday's IV jump in the sector. 

Looking further out, the March 17 expiration for XLU, which includes both the February and March Fed meetings, is currently showing an ATM Straddle premium of 7.4%.  Remember, at that point, markets are predicting a 27% chance that rates will be further higher. 

The ATM Straddle Premium for June 16 (two more Fed meetings down the road from March 17) is sitting at 10.4%.  It is sitting at 15.2% for the January 19, 2018, expiration.