Rates are ‘extreme.’ Expect a rally in bonds, utilities, says trader

Utilities have been kicked around this year. That could change soon, says one trader, who is making a contrarian call on the space.

“Trading utilities and trading bonds, it’s all about anticipating narratives on Wall Street,” Larry McDonald, founder of Bear Traps Report, told CNBC’s “Trading Nation” on Thursday.

The current narrative has not been a kind one to rate-sensitive stocks such as utilities. Where a slow-and-steady Federal Reserve last year kept the sector in neutral, signs of rising inflation and expectations of at least three rate hikes this year have had investors fleeing from the so-called safe stocks.

“We had tax cuts, now we’re talking about infrastructure, now we’re talking about inflation, so the entire narrative has gone 180,” said McDonald.

Just five months ago, he adds, Wall Street was preoccupied with rising tensions in North Korea, diminishing chances Congress could pull off tax reform, and a string of hurricanes that battered Texas, Louisiana, Florida and Puerto Rico. That uncertainty helped utilities post monthly gains in October and November.

Now, investors are keeping a closer eye on inflation after a year in which the economic metric atrophied alongside wage growth. Consumer and producer prices ticked up in January, a key indicator of rising inflation, while the January jobs report showed the best increase in wage growth since 2009.

“There’s just too many people in the inflation boat now. We’ve gone from disinflation being a massively crowded trade and now we’re really too bought into inflation at this moment,” said McDonald. “Treasurys has reached extreme levels; we believe there is a high probability of counter trend rally in bonds and utilities in the near term,” he added.

Utilities are considered defensive stocks that are heavily bought when the U.S. economy experiences weakness. The XLU Utilities ETF has fallen 5.5 percent so far this year, trailing the S&P 500‘s 2 percent rise. The ETF hit an all-time high of $57.23 on Nov. 15. Since then, it has fallen 13 percent, more than the 10 percent retreat representative of a correction.

Phil Streible, senior market strategist at RJO Futures, is not convinced that utilities are worth the risk as the Fed signals it is ready to continue in its rate hike cycle. The sector could be under increased pressure as its borrowing costs rise in line with increased interest rates.

“It’s cost of capital. It takes a lot of flows of funds to maintain and grow projects,” Streible said on “Trading Nation.” “Rising interest rates are going to cause that cost of capital to go up.”

In a rising rate environment, utilities stocks also face fiercer competition from bonds. Increased rates, and rising yields, often draw conservative investors away from dividend-paying defensive stocks.

“When you start looking at dividends versus coupon payments, it may not make sense to take that extra risk here,” said Streible. “With the Fed going to raise rates three times this year, I think there may be a better investment out there.”

The Fed is expected this year to continue to raise rates off historically low levels reached during the financial crisis. The central bank has increased the fed funds rate five times since December 2015. Markets are pricing in an 80 percent chance of a hike in March, according to CME Group fed fund futures.