Expectations of higher interest rates could be good for stocks in the coming months, though not for banking shares, according to a new analysis.
While the Federal Reserve isn't expected to raise rates for months, investors are beginning to brace for what will happen once the central bank starts tightening monetary policy as the economy improves.
One scenario, laid out Tuesday in an extensive analysis from Keefe, Bruyette & Woods, is that stock prices historically rise in anticipation of the initial rate increases, while financials underperform.
Once the rate increases begin, financials continue to slump but then recover in the six months after the final increase, KBW said.
With such a trend in place the firm said investors will need to choose wisely when picking investments in financials.
"We think you need to be pretty selective about banks amid rising rates," KBW analyst Fred Cannon said in an interview. "The future is always a little different than the past and this time that certainly will be the case."
Investors in the broad market have been looking forward to a rate increase as a signal that the economy is starting to recover. They got their first taste of the Fed repositioning itself for changing conditions when the central bank last Thursday announced it was hiking the discount rate it charges banks for emergency borrowing.
Stocks had a muted reaction to the move as Fed officials reassured the markets that it was not ready to back off its accommodative monetary policy until conditions improve more. Most analysts say the Fed funds rate is likely to stay extremely low until unemployment gets below 9 percent and the housing market shows stronger signs of improvement.
In this climate, KBW says investors should avoid banks that have mostly fixed-rate loans and a higher rate on deposits.
For example, banks that did not lower their lending rates to correspond with the sharp cut in the Fed funds rate conversely will not benefit once the rate starts rising. The funds rate's biggest impact is on its tie to consumer borrowing rates.