Last week, the Federal Reserve raised its interest rates as was widely expected at its recently concluded meeting. This is the third rate hike since Dec 2016, indicating that the central bank believes that the outlook for inflation remains bright despite recent soft readings. During the meeting, Fed officials have also indicated that there might be one more hike this year along with three more in the coming year.

Additionally, the central bank provided more details on the unwinding of its massive $4.5 trillion balance sheet. Moreover, the House of Representatives voted along party lines to remove a number of financial regulations put in place after the 2008 financial crisis.

An increase in interest rates would benefit banks and insurance companies since they would experience an increase in margins. Meanwhile, reducing the size of the Fed’s balance sheet would also have a positive impact on financial sector. Adding financial mutual funds which hold stocks from these sectors to your portfolio would make good sense at this point.

Fed Hike Interest Rates despite Softening Inflation

Fed officials raised benchmark federal funds rate for the third time in six months from 1% to 1.25% at its June 13-14 meeting. Additionally, Fed officials reiterated their projections of one more rate increase in 2017, followed by three hikes each in 2018 and 2019.  The central bank hiked interest rates for the second time this year amid expectations that inflation is still short of central bank's target.

As per the Labor Department, overall CPI rose 0.2% in May, less than 0.4% rise in April, showing that inflation has slowed down. The CPI rose 1% over the past twelve months. Core-CPI also gained 0.2%, in line with the consensus estimate. The annual inflation stayed lower than Fed’s target of 2%. However, Fed Chairwoman Janet Yellen believes inflation would reach its targeted level by 2018.

Shrinking the Fed’s Balance Sheet

The Fed also provided details on unwinding of its massive $4.5 trillion balance sheet at its recently concluded policy meeting last week. The Fed enlarged its balance sheet to around $4.5 trillion during the Great Recession even as it attempted to combat the fallout of a large scale financial crisis.

Now, the central bank has indicated that it will gradually reduce the quantum of its monthly bond purchases. Initially, the Fed expects to slash bond purchases by $10 billion, including $6 billion from Treasuries and $4 billion from mortgage-backed securities (MBS).

Killing off Dodd-Frank

The “crown jewel” of the GOP-led regulatory reform act was passed by the House lawmakers on June 8, which wiped out the Dodd-Frank regulations of the Obama administration. The Financial Choice Act passed the House with a 233-186 majority despite resistance from Democrats. It is aimed at replacing major portions of the Dodd-Frank law. House Financial Services Chairman Jeb Hensarling shaped the bill which aims to dissolve stringent financial regulations that would help to bolster economic growth as well as generate employment opportunities.

Some of the important changes that the Bill proposes include changes in the Volcker Rule that was formulated after the financial crisis. It proposes to repeal the Volcker Rule, which prevent banks to use their own funds to make certain types of investments in order to increase their profits. These investments are not believed to be beneficial for their customers. Needless to say, repeal of such a law would give banks more power to decide on their investment strategy.

Separately, Trump moved a step closer in eliminating key provisions of Dodd-Frank by nominating Dodd-Frank skeptic, Jim Clinger to chair the Federal Deposit Insurance Corp (FDIC). Clinger needs to get confirmed by the Senate when present FDIC Chairman Martin Gruenberg’s term completes. The bill still requires Senate approval to overhaul the Dodd-Frank regulations.   

CFPB Overhaul

The Bill would provide the President authority to sack heads of the Consumer Financial Protection Bureau (CFPB) and the Federal Housing Finance Agency which supervise the working of mortgage giants Fannie Mae and Freddie Mac. CFPB’s inability to inspect bank practices will also bolster power to banking regulators.

It also provides Congress the control over CFPB’s budget, by which lawmakers get power to stop funding the agency completely. Currently, banks are required to submit their plans annually on how the bank’s operation can be closed in case of insolvency without impacting the financial stability. Under the GOP proposal, major banks would be required to submit their plans to regulators every two years rather than annually.

How Will Banks, Insurance Benefit?

Banks are among the first gainers when central bank raises key interest rates. Interest rate hike will enable banks to earn higher profits, since higher interest rates will increase the spread between what banks earn by funding longer-term assets with shorter-term liabilities.

Moreover, investment income constitutes a major portion of income for insurance companies. A rise in rates will increase the investment income which in turn will have a positive impact on investment yields. Hence any increase in the interest rate would lead to gains for both banks as well as insurers.

The gradual approach of the central bank toward shrinking of the $4.5 trillion balance sheet will increase the supply of Government bonds which in turn will lower the bond price. This will eventually help interest rates move even higher.

4 Financial Mutual Funds to Consider

As discussed, these positive trends make investment choice in sound banking and insurance stocks judicious. We have, thus, selected four such financial mutual funds which have a Zacks Mutual Fund Rank #1 (Strong Buy) or Rank #2 (Buy). Further, these funds have minimum initial investment within $5000. These funds have low expense ratios.

We expect these funds to perform better than their peers in the future. Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but also on the likely future success of the fund.

Fidelity Select Financial Services Portfolio (FIDSX - Free Report) seeks capital appreciation. This financial fund invests at least 80% of assets in common stocks of companies principally engaged in providing financial services to consumers and industry. The fund invests in both U.S. as well as non-U.S. issuers.

The fund has YTD returns of 4.1% and an expense ratio of 0.76% compared with the category average of 1.39%.  As of April 2017, FIDSX had 5.69% of its assets invested in Capital One Financial Corp, 5.42% of its assets in Citigroup Inc and 5.27% of its assets in Bank of America Corporation.  

FIDSX has a Zacks Mutual Fund Rank #1.   

JHancock Regional Bank Fund A (FRBAX - Free Report) invests lion’s share of its assets in equity securities issued by regional banks. These regional banks may include commercial banks, industrial banks, savings and loan associations, and financial and bank holding companies. The fund may also invest in other domestic as well as foreign financial services companies. The fund seeks growth of capital for the long run.

The fund has YTD returns of 0.3% and an expense ratio of 1.27% compared with the category average of 1.39%. FRBAX had 3.45% of its assets invested inKeyCorp, 3.25% of its assets in US Bancorp and 3.24% of its assets in SunTrust Banks Inc.  

FRBAX has a Zacks Mutual Fund Rank #2.    

Fidelity Select Insurance Portfolio (FSPCX - Free Report) seeks capital appreciation. The fund invests a lion’s share of its assets and in no event less than 25%, in securities of companies principally engaged in underwriting, reinsuring, selling, distributing, and placing insurance.

The fund has YTD returns of 8% and an expense ratio of 0.79% compared with the category average of 1.39%. FSPCX had 10.43% of its assets invested inChubb Ltd, 9.99% of its assets in American International Group Inc and 6.80% of its assets in MetLife Inc.       

FSPCX has a Zacks Mutual Fund Rank #2.     

T. Rowe Price Financial Services (PRISX - Free Report) seeks both capital growth and current income. The majority of its assets are invested in companies in the financial services sector. PRISX may also purchase securities of companies with significant linkages to the sector.

The fund has YTD returns of 6.5% and an expense ratio of 0.88 % compared with the category average of 1.39%. PRISX had 4.76% of its assets invested inJPMorgan Chase & Co, 4.40% of its assets in Citigroup Inc and 4.21% of its assets inWells Fargo & Co. 

PRISX has a Zacks Mutual Fund Rank #2.