U.S. equity exchange-traded funds recorded more than $4 billion in outflows during the past week as investors increased their bets on another Federal Reserve interest rate hike.
According to Jefferies, ETFs that are particularly sensitive to changes in interest rates accounted for much of the selling pressure. Consumer discretionary and technology-related funds were among the areas affected.
The shift came as markets prepared for Wednesday’s Federal Reserve decision, with investors increasingly expecting policymakers to raise interest rates by another 25 basis points.
Inflation Data Raises Fed Rate Hike Expectations
Wall Street ended the holiday-shortened week lower, with the S&P 500 breaking a two-week winning streak and falling nearly 1%.
The decline followed fresh producer and consumer inflation data showing that price pressures remain elevated.
Those reports caused expectations for another Federal Reserve rate hike to rise sharply.
Markets were pricing in roughly an 87% probability of a 25-basis-point increase, compared with about 59% one week earlier.
Persistent inflation has increased concerns that the Federal Reserve may need to keep monetary policy restrictive for longer than investors previously expected.
Treasury Yields Approach the 5% Level
Rising expectations for higher interest rates also intensified the sell-off in U.S. government bonds.
As bond prices fell, Treasury yields moved sharply higher.
The benchmark U.S. 10-year Treasury yield climbed around 19 basis points during the week to 4.975%, bringing it close to the psychologically important 5% threshold.
Higher Treasury yields can create pressure for equity markets because investors receive increasingly attractive returns from lower-risk government bonds.
They can also increase borrowing costs for businesses and consumers.
U.S. Equity ETF Outflows Reach $4.45 Billion
Against this challenging backdrop, investors withdrew approximately $4.45 billion from U.S. equity ETFs during the week.
That represented a sharp reversal from the previous week, when the funds attracted roughly $1.35 billion in net inflows.
The three largest ETFs tracking the S&P 500 together suffered billions of dollars in withdrawals.
Jefferies analysts highlighted significant differences in investor flows among large-cap core equity ETFs, with the iShares Core S&P 500 ETF experiencing particularly heavy withdrawals.
The movement suggests investors are becoming more selective as uncertainty surrounding interest rates, inflation and bond yields increases.
Nasdaq 100 ETF Sees Investors Pull Back
Technology-focused ETFs also came under pressure.
The Invesco QQQ Trust, which tracks the Nasdaq 100, recorded approximately $588.6 million in outflows during the week.
That marked a significant turnaround from the previous week, when QQQ attracted about $2.62 billion.
Technology stocks can be especially vulnerable when interest rates rise.
Many technology companies are valued partly on expectations of strong profits far into the future. Higher interest rates reduce the present value of those future earnings, which can place downward pressure on valuations.
Higher borrowing costs can also make it more expensive for growth companies to finance expansion.
Consumer Discretionary ETFs Also Face Selling
Consumer discretionary ETFs recorded approximately $528.3 million in outflows during the week.
This sector can also face greater pressure in a higher-interest-rate environment.
Rising borrowing costs can reduce consumers’ ability to finance purchases, while higher credit card, auto loan and mortgage rates can leave households with less disposable income.
If consumer spending weakens, companies that depend heavily on discretionary purchases may see slower revenue growth.
High-Yield Bond ETFs Remain Under Pressure
Weakness was not limited to equity markets.
High-yield fixed-income ETFs suffered more than $900 million in withdrawals for a second consecutive week as the bond market sell-off continued.
Jefferies analysts said persistent outflows from high-yield funds are an important development to monitor.
If the trend continues, companies with weaker credit ratings could face more difficult financing conditions. New bond issuance could slow, while credit spreads may widen.
Investment-grade bond funds also experienced significant withdrawals during the week.
Some ETF Categories Continue to Attract Investors
Despite the overall weakness in fund flows, investor sentiment was not negative across every part of the ETF market.
Jefferies noted that roughly as many ETFs attracted money as experienced withdrawals during the week.
Broad total-market funds continued to record inflows, with investor demand running ahead of comparable levels from last year.
Financial sector ETFs also experienced renewed inflows.
Meanwhile, low-volatility and healthcare funds attracted fresh capital as some investors appeared to favor more defensive areas of the market.
Fed Decision Could Drive the Next Market Move
Investors are now focused heavily on the upcoming Federal Reserve meeting.
A 25-basis-point interest rate increase could reinforce concerns that borrowing costs will remain elevated for longer, potentially creating additional pressure on stocks and bonds.
Technology and consumer discretionary shares may remain particularly sensitive to changes in rate expectations.
However, much will also depend on the Federal Reserve’s guidance about future policy.
A more aggressive message on inflation could push Treasury yields higher and increase ETF outflows. A less hawkish outlook, on the other hand, could provide some relief for risk assets.
For now, the $4.45 billion withdrawal from U.S. equity ETFs highlights the growing caution among investors as markets prepare for another potentially significant Federal Reserve decision.
