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Stable stocks like consumer staples are seen as a good bet when interest rates fall

Key Points
  • The Federal Reserve's policy reversal on interest rates has driven benchmark yields to the lowest levels in more than a year.
  • The consumer staples sector has emerged as a preferred defensive play in an environment of falling rates, according to Deutsche Bank.
  • There are signs that investors have started rotating out of cyclical sectors like financials while buying into defensive ones, says Larry McDonald, founder of The Bear Traps Report.
A PepsiCo Inc. employee delivers beverage products to a ShopRite Holdings Ltd. grocery store in Stratford, Connecticut.
Paul Taggart | Bloomberg | Getty Images

The Federal Reserve's policy reversal on interest rates has driven benchmark yields to the lowest levels in more than a year. For stock investors, the environment of falling rates is now favoring one particular sector: consumer staples.

These stocks have been long viewed as defensive plays at times when investors are trying to avoid risk, because of their stability and high dividends. But the central bank's series of rate hikes in recent years dampened the appetite for consumer staples stocks as U.S. Treasury yields rose and other sectors scored faster growth.

Now, consumer staples are back in favor after the Fed signaled it would pause interest rate increases and as the economic outlook weakens.

"How to play declining rates tactically within equities? As is well known, falling yields are positive for defensive bond-like sectors and growth stocks; negative for Financials, cyclicals, small caps and traditional value stocks," Binky Chadha, Deutsche Bank's chief strategist, said in a note Wednesday.

There are signs that investors have started rotating out of cyclical sectors like financials while buying into defensive ones, said Larry McDonald, founder of The Bear Traps Report. He pointed out that the performance of the Consumer Staples Select Sector SPDR Fund and Financial Select Sector SPDR Fund began to diverge in recent weeks.

Low rates might be here to stay as markets are pricing in a more than 70 percent chance of at least one rate cut by Dec.11, according to the CME's FedWatch tool.

Stephen Moore, a Heritage Foundation fellow who is expected to be nominated by President Donald Trump for an open seat at the Fed, told The New York Times this week that the central bank should "immediately reverse course and cut rates by half a percentage point. "

Consumer staples are a preferred tactical play now because other defensive sectors like real estate investment trusts and utilities have already priced in the drop in rates, Deutsche's Chadha noted.

"By contrast Consumer Staples which are still priced for a significantly higher 10y yield (closer to 3%), would be the preferred play, with upside even if rates and growth stay at current levels, more so if they decline further," Chadha said.

The U.S. 10-year Treasury yield touched new 14-month low Wednesday. Yields move the opposite of prices.