Update – XLU: Must Yield?

by CC March 8, 2017 2:23 pm • Trade Updates

Last week we looked at utility stocks (XLU) after their somewhat counter-intuitive breakout from consolidation the past few weeks. We detailed a trade idea to position for a pullback that could reverse some of the recent gains, especially as we get close to a rare FOMC rate hike.  Here was the trade idea and rationale, from March 3rd:

So what’s the trade?

XLU ($51.15) Buy April 51 / 47 put  spread for $1
  • Buy 1 April 51 put for 1.20
  • Sell 1 April 47 put at 20 cents

Rationale – The utility stocks ripped in February on a technical breakout. But we’re heading into a rising rate environment and positioning XLU to reverse some of the recent games makes sense in that environment. The 1 to 3 payout potential is nice with volatility fairly low. On the downside 49 is a realistic area to target and perhaps a place to take profits. On the upside, last Summer’s highs near 53 can be used as a stop.

XLU has backed off a bit and with the etf now 50.75 the trade is a slight winner. Obviously it’s a long way to go until April expiration so no moves need to be made at this point, but it is interesting on what to keep an eye on for this trade. XLU is somewhat a bond proxy as it’s made of of high yield stocks. Typically, when interest rates go higher utility stocks should under-perform the market and when rates go lower they should outperform (as they are more attractive than bonds in that scenario). However, it isn’t that cut and dry. Because we’re at such historically low interest rates the reaction in the utility stocks may be more complicated. And the biggest factor could simply be the Fed’s pace of rate hikes. If the FOMC hints at a fairly regular pace of hikes at the March meeting, you could easily see high yield stocks face some selling. But that hasn’t been the Fed’s style in recent years, and it’s much more likely they announce a hike and fall back on similar language that go them here. And what about that pace of rate hikes? From Peter Boockvar today:

The 2 yr note yield touched 1.36%, the highest since June 2009. We are now above 50% odds of a 3rd hike this year.

Utility stocks have held up well going into this rate hike. They’ve been caught up in the strength of the broader market and investors don’t seem to concerned about the rate environment. But increasing expectations of future hikes could be what changes that dynamic, and today’s price action could be a preview.