It's beginning to look very likely that the Federal Reserve will have to hike its target interest rate sooner rather than later.
The Fed's preferred measure of inflation -- the Personal Consumption Expenditures Price Index -- was published last week by the Bureau of Economic Analysis, and it wasn't pretty.
According to the index, prices rose 4.1% year over year in May, and 3.4% when volatile food and energy prices are excluded. Both measures are well above the Fed's 2% target for year-over-year inflation. The Consumer Price Index, published earlier in June, had similar readings -- 4.2% year over year for all items and 2.9% excluding food and fuel.
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The labor market also looks strong right now. Monthly gains in net jobs have averaged more than 188,000 during the past three months, which means the Fed can afford to hike rates right now.
In addition, a Supreme Court ruling this week protecting the Federal Reserve from arbitrary firings by the president affirms the Fed's independence and should give it the confidence to raise rates as it sees fit, without much political interference or backlash.
Futures markets are pricing in a rate hike in September
That's probably why futures markets now see a 63% chance that the Fed will hike its target rate at the September meeting of the monetary policy committee. Futures traders are also pricing in an 80% chance that the Fed's benchmark interest rate will be higher a year from now.
So, interest rates look like they're poised to start climbing higher and will stay there.
Although many companies take a hit when rates climb -- because of higher interest costs on their debt and slower consumer spending, among other factors -- some financial stocks benefit from a higher-rate environment.
You can already see this reflected in stock prices, which generally anticipate profit changes during the next 12 to 18 months.
Over the past month, as Fed rate hikes this year have begun to look increasingly likely, the State Street Financial Select Sector SPDR ETF (XLF 0.20%), which tracks the S&P 500 financial sector, has significantly outperformed the broader market, as measured by the S&P 500 index. The fund is up about 4.2% during the past month, while the broad S&P 500 is down about 2%.
Banks, insurers, and brokerages can benefit from higher interest rates
Which financial stocks benefit the most in such an environment?
Well, when interest rates rise, big banks like JPMorgan Chase (JPM 0.63%), Wells Fargo (WFC 1.04%), and Bank of America (BAC 1.55%) will begin to see the gap between what they pay on deposits and what they make on loans -- known as the net interest margin -- widen, which means higher profits.
During the Fed hiking cycle of 2022-2023, JPMorgan Chase generated record net interest income that exceeded $90 billion and helped the bank achieve its most profitable year ever. Bank of America also saw a surge in interest income.
NYSE: JPM
Key Data Points
With higher rates, brokerages like LPL Financial Holdings (LPLA +4.62%) and Charles Schwab (SCHW +1.90%) will earn more on the large amounts of cash they hold for clients. These firms tend to hold that cash in short-term securities for liquidity reasons, and those short-maturity bonds are the most sensitive to Fed rate hikes.
Insurance companies also benefit from higher rates. These companies invest the premiums they collect into fixed-income securities like bonds. When rates rise, they can purchase new government and corporate bonds at higher yields and enjoy better returns on their giant portfolios. Examples of these companies include Berkshire Hathaway (BRKA +0.72%) (BRKB +0.89%), which owns multiple insurers, and Allstate (ALL 1.43%).
NYSE: BRKB
Key Data Points
So although higher interest rates are a headwind for some companies, they can be a strong tailwind for many companies in the financial sector. It's worth looking at rebalancing your portfolio when it looks like rates will climb.
