Interest rate hikes generally have a favorable impact on financial sector ETFs like the Financial Select Sector SPDR Fund.
Expanded Net Interest Margins (NIM)
Banks benefit from higher interest rates because the spread between what they earn on loans (like mortgages and commercial loans) and what they pay out on deposits widens. This increase in NIM directly boosts bank profitability which represents a large portion of financial ETFs.
Increased Lending Income
As the central bank raises benchmark rates, variable-rate loans adjust upward immediately. New loans are issued at higher yields and increase revenue for retail and commercial banks.
Impact on Insurance Companies
Insurance firms hold massive portfolios of fixed-income assets to back their underwriting liabilities. Higher interest rates allow them to reinvest premium cash flows into newly issued higher-yielding bonds.
Risks and Headwinds
While higher rates boost margins, excessively aggressive rate hikes can slow down economic growth. This leads to reduced demand for new loans and a higher risk of loan defaults (non-performing loans). Investment banking divisions may also see a slowdown in mergers and acquisitions (M&A) and initial public offerings (IPOs) due to more expensive financing costs.