Recent U.S. economic and inflation data have shown signs of weakening, and expectations for Federal Reserve rate cuts rise again.

As of July 19, the CME FedWatch Tool indicates a 90% probability that the Federal Reserve will cut rates by 25 basis points to 5%-5.25% in September.

Moreover, the market expects two additional rate cuts in the year's second half, potentially bringing the year-end rate down to around 4.5%.

If these expectations materialize, it will mark the first reversal since the rate hike cycle began in 2022.

Standing at the threshold of a rate-cutting cycle, industries suppressed by the high-interest-rate environment will likely see a brighter future. The biotech sector is one of the chief beneficiaries.

Interest-rate sensitive sector

The performance of the biotech sector is highly correlated with macroeconomic conditions, particularly the Federal Reserve's interest rate policies.

Take the S&P Biotech ETF ($SPDR S&P Biotech ETF(XBI.US)$) as an example. After the onset of the pandemic, the Federal Reserve slashed policy rates to zero, propelling XBI into a bullish trend.

However, after 2021, the Federal Reserve began a rate hike cycle and XBI experienced a pullback of over 60%.

In the second half of 2022, the Fed entered a "Higher For Longer" policy phase, where the pace of rate hikes slowed or stopped, but the duration of high rates was extended.

The biotech index's performance turned volatile, oscillating between 60 and 100 over approximately two years in this high rate environment.

For instance, in October 2023, inflation control faced setbacks, and the market anticipated that the Fed might hike rates further to curb inflation.

During this period, the yield on the U.S. 10-year Treasury briefly exceeded 5%, reaching its highest level since this rate hike cycle began. Concurrently, the XBI index kept declining, hitting a secondary bottom.

As inflation began to ease, market expectations for Federal Reserve actions shifted from further hikes to holding steady and preparing for rate cuts. This led to a rebound in XBI.

However, despite this recovery, the sector couldn't break through effectively. It was like the high rates acted as an invisible hand suppressing its performance.

Source：moomoo Data as of market close on July 19, 2024.Investing involves risk and the potential to lose principal. Past performance does not guarantee future results. This is for information and illustrative purposes only. It should not be relied on as advice or recommendation.

Why do rate cuts benefit the biotech sector?

Biotech companies possess both healthcare and technology attributes. Prominent healthcare firms like Merck ($Merck & Co(MRK.US)$) and Eli Lilly ($Eli Lilly and Co(LLY.US)$) have continued to hit new highs despite rate hikes.

Meanwhile, tech stocks represented by NVIDIA and Microsoft have been leading the market. Why do biotech companies, which combine elements of both industries, appear to be so sensitive to interest rates?

We previously discussed biotech companies. Though part of healthcare, they differ significantly from well-known pharmaceutical companies (Pharm).

Biotech companies are often small to mid-sized enterprises. Their business can be highly volatile due to the reliance on the development of a single drug, and their cash flows are typically unstable.

Developing new drugs requires enormous amounts of capital and time, and the failure rate is high—historically, about 90% of new drugs fail to get approval.

In this period, biotech companies may not be profitable for an extended time. They highly depend on venture capital funds or Initial Public Offerings (IPOs) for financial support.

On the other hand, "Pharm" usually refers to large pharmaceutical companies that tend to have more stable cash flows and multiple drug development pipelines. Their stock prices are less susceptible to the success or failure of a single drug.

The primary revenue source for large pharmaceutical companies often includes previously developed and still-patent-protected drugs, which helps smooth out business cycle fluctuations.

Additionally, these companies usually have diversified portfolios like medical devices and healthcare services.

Funding is the lifeblood of biotech companies. Without a continuous influx of capital, biotech firms often face significant difficulties. Interest rates are crucial because they directly impact the cost of capital.

During periods of low interest rates, the biotech sector typically sees a flurry of financing and mergers and acquisitions.

Even without external financing, companies can borrow at relatively low costs to sustain their daily operations.

However, the easy money is gone in a high-interest-rate environment.

Oppenheimer, a leading investment bank, reported 245 financing activities in the biotech sector during the ultra-low interest rate period in 2020. Even in 2021, as inflationary pressures began to emerge, there were nearly 200 activities.

However, in 2022, when the Fed started to hike rates, biotech financing was cut in half, falling to around 100.

Although there has been some recovery over the past two years, the high-interest-rate environment has prevented a return to previous levels.

How to invest in biotech stocks

Biotech companies often perform well around the onset of a rate-cutting cycle.

Morgan Stanley recently published a report analyzing the historical correlation between rate cuts and the biotech sector.

The report found that the biotech sector consistently outperformed the market in the months leading up to the first rate cut, but followed by roughly a month of underperformance. And then, biotech stocks typically began to rise again, often appreciating by about 20% to 30% six to 12 months out.

Biotech stocks tend to be from smaller companies with complex drug development processes, resulting in significant price volatility.

According to Nasdaq, while investing in biotech stocks is generally the more popular choice, ETFs are a way to mitigate some of the risks that are inherent in investing in stocks.

Here are a few biotech-related ETFs with total assets of more than $1 billion for you to consider:

• IBB($iShares Biotechnology ETF(IBB.US)$) and XBI ($SPDR S&P Biotech ETF(XBI.US)$): Both are large-scale ETFs, each with nearly $8 billion in assets under management.

• ARKG ($ARK Genomic Revolution ETF(ARKG.US)$): An actively managed  ETF under Cathie Wood's ARK Invest.

• LABU ($Direxion Daily S&P Biotech Bull 3x Shares ETF(LABU.US)$) and LABD ($Direxion Daily S&P Biotech Bear 3x Shares ETF(LABD.US)$): These are leveraged ETFs designed to provide three times the daily performance of the biotech sector, either long (LABU) or short (LABD).

It is important to note that while leveraged ETFs can offer higher returns, they can also amplify losses and may incur operational decay over time.

Related risks

Interest Rates May Not Fall as Expected: Although the market currently sees a rate cut by the Federal Reserve as a near-certainty, there's always a possibility that inflation could rebound in the coming months, causing the Fed to delay its actions. This could lead to a pullback in the biotech sector.

The Fed is scheduled to hold a policy meeting at the end of July, with the interest rate decision to be announced in the afternoon of July 31 local time. Investors could keep an eye on this event.

High Volatility: Factors such as research and clinical trial outcomes, regulatory approvals, market competition, and investor sentiment can significantly impact the performance of biotech companies.

Given that many companies in this sector have relatively small market capitalizations, the overall volatility might be high.

Additional Disclosures: This content is also not a research report and is not intended to serve as the basis for any investment decision. The information contained in this article does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Furthermore, there is no guarantee that any statements, opinions or forecasts provided herein will prove to be correct.