Sector Showcase: The Utility Of Utilities For Handicapping The Fed

Utilities are often called "widow and orphan" stocks for the stable, lower-risk income they can provide. In addition to having minimal sensitivity to broader macroeconomic trends, the utility sector has the highest dividend yield (3.26%) of the major sector ETFs we track.

Beyond representing stable investments, utility stocks also have utility (pun intended) as an indicator for the market's interest rate expectations. In essence, the relatively high yields offered by utility stocks are more attractive in low or falling interest rate environments and less attractive in high or rising interest rate environments. Therefore, relative weakness in utility stocks tends to show that investors are more confident that interest rates are heading higher and relative strength in utilities shows skepticism about rising interest rates.

As the below chart of the utility sector's performance relative to the broader market (XLU/SPY) shows, we're starting to see the latter scenario play out:

Source: Stockcharts.com

 We should always be cautious about reading too much into a single chart, the impressive relative performance of utility stocks so far this year suggests that investors are less worried about aggressively rising interest rates than they were earlier. Other cross-market indicators of interest rate expectations, such as the relative performance of regional banks and REITs, are painting a similar picture.

At this point, it still seems highly likely that the Federal Reserve will raise interest rates at its highly-anticipated meeting in two weeks' time. Indeed, Fed Funds futures traders are pricing in about a 85% likelihood of that outcome, according to the CME's FedWatch tool, and we see little reason to fight the tide of nearly unanimous hawkish rhetoric from central bankers. That said, if we see a lukewarm NFP report on Friday, it would raise the chances of another "dovish hike," where the FOMC raises interest rates but strives to downplay expectations for future interest rate hikes this year. That scenario could result in continued strength in higher-yield utility and REIT stocks, as well as underperformance in regional banks and the US dollar.

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