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How to play the SPDR S&P Regional Banking ETF amid rising interest rates

News that the Federal Reserve raised interest rates for the first time in three years on 16 March boosted the price of the SPDR S&P Regional Banking ETF. Looking ahead, many analysts expect to see continued growth for regional banking stocks as quantitative easing begins to be wound down. 

The SPDR S&P Regional Banking ETF [KRE] has seen some much-needed relief as the US Federal Reserve approves a series of interest rate hikes at each of the six meetings this year to combat higher inflation.

After months of anticipation, the Federal Open Market Committee said it would raise rates by a quarter of a percentage point to between 0.25% and 0.5% for the first time since 2018 on 16 March. The news lifted the regional banking fund by more than 3% before ending the week up 2.6%, making it one of the best-performing investment themes of last week.

Before the announcement, the SPDR S&P Regional Banking ETF had been trending lower, falling 5.7% over the first two weeks of March. Regional banking stocks, such as KeyCorp [KEY], have underperformed since Russia’s invasion of Ukraine began in late February.

However, with the interest rate trajectory increasing, analysts believe that this will provide a key catalyst for banking stocks’ earnings. The Fed expects this to be the first of six rate hikes this year, with the rate likely to sit at 1.9% by the end of 2022. Three more hikes are forecasted for 2023.

Fed turns hawkish, despite doubts

The decision to raise interest rates is intended to combat rising inflation in the US, which grew to a 40-year high of 7.9% in February due to increasing prices for gas, food and housing, and slowing economic growth. 

“Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures,” the Fed said in a statement, according to CNBC.

Since the start of 2022 (through 18 March close), the fund has climbed 1.5% amid soaring inflation. It had reached a 52-week high of $78.81 during intraday trading on 14 January after a Fed meeting signalled dramatic quantitative tightening ahead.

Despite the Fed’s decision to go ahead with the rate rise, there had been some doubts in recent weeks. ARK Invest founder Cathie Wood suggested in a webinar on 8 March that the Fed may only raise interest rates once this year due to consumer sentiment – hit by rising inflation and the Russian invasion of Ukraine – being at levels not seen since the financial crisis.

Higher interest rates: A tailwind for regional banks

The SPDR S&P Regional Banking ETF is likely to benefit from a hawkish Fed, as it seeks to provide investors with exposure to the regional banks segment of the S&P Total Market Index. Higher interest rates mean more profit for banks from the likely increase in lending to businesses and consumers. It is also more attractive for savers.

“The rates charged will go up accordingly, and this typically happens at a faster pace than rates on deposits and savings increases. The end result is a net gain to profit and interest margins, and that provides an earnings tailwind for the underlying companies in the year ahead,” Dividend Seeker, a macro-focused investor, wrote on Seeking Alpha.

Tom Lydon, chief executive of ETFTrends.com, agrees and expects regional banks to be better positioned than the larger banks to benefit from a high-interest rate environment because “the rates they charge their client lenders rise too”. “Most of the regional bank revenue comes mostly from lending where larger banks have revenue more diversified into other areas like equity trading and other financial services,” Lydon told Fox Business.

Banking on growth: Merger mania

The regional banking sector is seeing an uptick in trading not just as a result of higher interest rates but also because of an increase in merger and acquisition activity. 

First Horizon [FHN], which is a top holding in the S&P Total Market Index, has gained 26.9% (through 18 March) since it announced that it was acquiring TD Bank Group for $13.4bn on 28 February.

The move was part of TD Bank’s long-term growth strategy and helped its Southeast expansion into the US. According to Zacks Investment Research, the markets where First Horizon operates in are forecasted to expand by 50% faster than the US national average.

In addition, the M&T Bank Corporation [MTB], which is also a top holding in the S&P Total Market Index, has risen 5.2% (through 18 March) since confirming a merger with People’s United Financial [PBCT] on 7 March. The deal is expected to close in April this year after the Fed gave the green light earlier this month.

The increase in deal activity is seen as a positive by analysts, as it allows regional banks to better compete with larger banking institutions. This coupled with a favourable interest rate landscape are expected to be strong tailwinds for the SPDR S&P Regional Banking ETF.   

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