By Rodrigo Campos
NEW YORK (Reuters) - U.S. equity investors could rotate out of high-yielding sectors and into stocks of banks, which would benefit from the next leg up in interest rates, after the Federal Reserve's policy-setting meeting wraps up on Wednesday.
If the Fed next week gives a nod to rising inflation or focuses its trimmed-down bond buying on longer-dated bonds as it winds down its balance sheet, there could be a shift around of preferred sectors, investors said.
"In the short run financials will benefit," said Chad Morganlander, portfolio manager at Washington Crossing Advisors, if the Fed action pushes long-term rates higher relative to short-term rates.
Next week's meeting is not expected to result in an interest rate increase, but investors will focus on how Fed Chair Janet Yellen characterizes recent inflation readings, for clues to the likelihood of a hike in December, as well as on how the U.S. central bank will begin to wind down its $4.5 trillion balance sheet.
Inflation has been persistently low but Yellen could dismiss this as transitory and point to recent stronger-than-expected data on consumer prices.
Any heightened expectations of a rate increase could fuel a rotation and "will certainly change leadership" among market sectors, favoring financials, industrials and materials, according to Jim Paulsen, chief investment strategist at The Leuthold Group in Minneapolis.
"It would put pressure on utilities and telecoms" as well as on companies that consistently increase quarterly paybacks to shareholders, he said.
Investors typically sell shares of utilities and telecoms as well as high dividend payers when interest rates rise, partly because they lose their appeal as bond proxies since investors can expect similar returns investing in bonds, which are seen as safer assets.
So far this year, the S&P 500 banking index <.SPXBK> is up less than 4 percent, underperforming the 9.2 percent gain in the S&P 500 dividend aristocrats index <.SPDAUDP>. S&P 500 utilities <.SPLRCU> are up 12 percent.
While the Fed's expected announcement of the trimming of its balance sheet has been well telegraphed, investors will look for any Fed reveal on its preference for shorter- or longer-dated bonds when it reinvests a portion of its maturing assets.
If the focus is on the repurchase of short-term assets, that would likely push the long end of the yield curve higher, driving investors' attention also to shares of banks, which would theoretically make more money with the help of higher net interest margins, said Morganlander.
Banks borrow money short term and lend it out longer term, so a steeper yield curve is seen as positive for their balance sheets.
However, long-term yields in the U.S. are not immune to the effect of low-yielding bonds in other developed countries like Germany and Japan.
"The general tendency based on global rates will continue to pressure the yield curve," Morganlander said.
BROAD MARKET TO SHRUG
While the Fed's quantitative easing program was a pillar of the U.S. stock market's march from then-12-year lows on the S&P 500 in 2009 to current record-high levels, winding it down is not expected to produce a major market reaction on the downside.
The U.S. central bank is expected to initially trim no more than $10 billion per month from its $4.5 trillion portfolio, with the cap rising each quarter for a year until it hits $50 billion monthly.
The slow and steady move would not turn the U.S. central bank into a seller. The Fed would allow assets to mature without reinvesting the totality of those maturing assets, which would trim some $300 billion from the Fed's portfolio after the first year according to analysts.
"It's going to be run-off, not outright sales, so that in and of itself is a very gradual process," said Art Hogan, chief market strategist at Wunderlich Securities in New York.
"The boldest, the most hawkish case, it is going to take well into the next decade for the balance sheet to get to its 'new normal' size," Hogan said. "Can the market stomach that? My supposition would be yes."
Estimates of where the Fed plans to take its balance sheet range from about $2 trillion to $3 trillion. The Fed's portfolio was close to $900 billion before the 2007-2009 financial crisis and ballooned to near $4.5 trillion by late 2014, where it has roughly stayed since.
(For a graphic on the growth of the Fed's balance sheet vs. the S&P 500 see: http://reut.rs/2jssUvS)
(Reporting by Rodrigo Campos, additional reporting by Jonathan Spicer; Editing by Meredith Mazzilli)