Fed Rate Cuts Are Coming: An ETF Playbook

With the Federal Reserve expected to cut rates, it’s time to consider how your portfolio is positioned for this shift. Rate cuts typically bring about significant changes in market behavior, and exchange-traded funds (ETFs) offer a flexible way to adjust your portfolio accordingly. Let’s look at the sectors and ETFs that could be considered to help you navigate this new environment.

1. Homebuilders: A Rate-Cut Winner

Lower interest rates tend to reduce mortgage costs, potentially reigniting demand for homes and boosting the housing market. Homebuilders stand to benefit from this dynamic, making them a solid play in the early stages of rate cuts.

• iShares U.S. Home Construction ETF (ITB): Offers exposure to homebuilders and companies involved in home improvement, which could see increased demand as lower borrowing costs boost home sales.
• SPDR S&P Homebuilders ETF (XHB): Provides broad exposure to the homebuilding sector, including materials and home improvement retailers, benefiting from increased housing market activity.

2. Small Caps: Positioned for Growth

Small-cap stocks, especially in the U.S., tend to perform well in a falling rate environment due to their reliance on domestic borrowing and growth. Lower rates reduce financing costs for smaller companies, giving them room to expand.

• iShares Russell 2000 ETF (IWM): This ETF provides broad exposure to small-cap U.S. companies, which could benefit from easier borrowing conditions and an improving economic outlook.
• Vanguard Small-Cap ETF (VB): Another option for exposure to small-cap stocks across various sectors, allowing investors to capture growth potential in a low-rate environment.
• Invesco S&P SmallCap Information Technology ETF (PSCT): While large tech companies may be overvalued, small-cap tech firms could see renewed interest. PSCT focuses on small-cap tech stocks, offering a more affordable entry into tech's growth potential and AI plays.

3. Defensive Play: Consumer Staples and Utilities

With the economy potentially heading into a recession, consumer staples and utilities become attractive for their stability. These sectors tend to outperform during economic slowdowns, providing steady dividends and reduced volatility.

• Consumer Staples Select Sector SPDR Fund (XLP): This ETF focuses on large companies that provide essential goods, making it a solid defensive play as consumers tighten their wallets.
• Utilities Select Sector SPDR Fund (XLU): Utilities benefit from consistent demand and provide investors with stable dividends. XLU offers exposure to large utility companies that could outperform in a volatile market.

4. Income Focus: REITs and Dividend Stocks

As rates fall, income-producing assets such as REITs (Real Estate Investment Trusts) and high-dividend stocks become more attractive. These assets tend to benefit from lower financing costs and investor demand for yield.

• Vanguard Real Estate ETF (VNQ): This ETF provides exposure to a wide range of REITs that could benefit from lower interest rates and stronger real estate demand.
• Schwab U.S. REIT ETF (SCHH): Another solid option for REIT exposure, focusing on high-quality real estate investments that stand to gain from favorable financing conditions.
• iShares Select Dividend ETF (DVY): This ETF focuses on high-dividend stocks in sectors like utilities, energy, and consumer staples, providing consistent income in a low-rate environment.
• Schwab U.S. Dividend Equity ETF (SCHD): Offers exposure to high dividend-yielding U.S. stocks, providing a steady income stream as investors seek yield.

5. Commodities and Precious Metals

A weaker dollar resulting from rate cuts can drive up commodity prices. While activity commodities such as oil and copper might be influenced by recession worries, precious metals are likely to benefit more from Fed rate cuts due to reduced funding costs.

• SPDR Gold Shares (GLD): Gold typically gains during periods of economic uncertainty and falling interest rates. GLD is one of the most liquid gold ETFs, making it a reliable hedge.
• VanEck Vectors Gold Miners ETF (GDX): Offers exposure to gold mining companies, which can benefit from rising gold prices due to their direct link to the price of gold.
• iShares Silver Trust (SLV): Provides exposure to silver, which, like gold, benefits from a weakening dollar and serves as a hedge against inflation and economic uncertainty.

6. Currency Play: Japanese Yen and Swiss Franc

The U.S. dollar typically weakens in response to rate cuts, making safe-haven currencies like the Japanese yen and Swiss franc more attractive. If you're looking to diversify currency risk, consider adding yen exposure to your portfolio.

• Invesco CurrencyShares Japanese Yen Trust (FXY): This Japanese yen ETF provides direct exposure to the Japanese yen, offering a hedge against a weakening U.S. dollar in a falling rate environment.
• Invesco CurrencyShares Swiss Franc Trust (FXF): Offers exposure to the Swiss franc, another safe-haven currency that can benefit from a weaker dollar and economic uncertainty.

7. Fixed Income: Shorter Duration Bonds and TIPS

Falling interest rates increase the value of existing bonds, but investors should be cautious with long-duration bonds as inflation risks rise. Inflation-protected securities (TIPS) offer a way to maintain income while hedging against future inflation.

• iShares 1-3 Year Treasury Bond ETF (SHY): This ETF provides exposure to short-term Treasury bonds, reducing interest rate risk while offering steady income.
• iShares TIPS Bond ETF (TIP): TIP offers protection against inflation, making it a smart addition as inflationary risks grow in a low-rate environment.
• Vanguard Short-Term Inflation-Protected Securities ETF (VTIP): Provides exposure to short-term TIPS, offering inflation protection with lower interest rate risk.

8. Yield Curve Disinversion: Steepener ETFs in Play

A rate cut by the Fed often leads to a steepening of the yield curve, meaning the difference between short-term and long-term interest rates increases. This can benefit certain bond strategies.

• Amundi US Curve Steepening 2-10Y UCITS ETF (STPU): This ETF aims to benefit from a steepening yield curve between 2 and 10 years, providing a direct play on the anticipated widening of the yield gap.