Recently, the U.S. economy and inflation data has weakened, leading to a renewed expectation for interest rate cuts from the Federal Reserve.

According to the CME rate observation tool, as of July 19, the market expects there is over a 90% probability that the Federal Reserve will cut rates in September, lowering the rate by 25 basis points to 5%-5.25%.

In addition, the market also predicts two more rate cuts in the second half of the year, with the year-end rate possibly dropping to around 4.5%. If this develops as expected, it will be the first shift since entering the interest rate hike cycle in 2022.

Standing at the threshold of a rate-cutting path, sectors constrained by a high interest rate environment are also expected to "see the light after the clouds," with the biotechnology (Biotech) sector being one of them.

Interest rate sensitive Sector

The performance of the biotechnology Sector is highly correlated with the macroeconomy, especially the Federal Reserve's interest rate policy.

Taking the S&P Biotechnology ETF ($SPDR S&P Biotech ETF(XBI.US)$) as an example, after the outbreak of the pandemic, the Federal Reserve lowered the policy interest rate to 0, and XBI also experienced an upward trend. After 2021, as the Federal Reserve entered a rate hike cycle, XBI experienced more than a 60% pullback.

In the second half of 2022, the Federal Reserve entered the "Higher For Longer" policy phase, which extended the duration of maintaining high interest rates while slowing and pausing interest rate hikes.

The trend of the biotechnology index also shifted to a volatile market, fluctuating repeatedly in the range of 60-100 for about two years, with its movement significantly influenced by the interest rate environment in the United States.

For example, during October 2023, the anti-inflation process encountered setbacks, and the market even developed expectations for the Federal Reserve to further raise interest rates to curb inflation. The U.S. ten-year Treasury yield also briefly exceeded 5% during this period, hitting the highest point since the rate hike cycle began; meanwhile, the XBI index continuously declined, experiencing a second bottom.

However, as inflation eased, the market's expectations for the Federal Reserve shifted gradually from interest rate hikes to holding steady, and then to preparing for rate cuts. XBI experienced a rebound. Nevertheless, it still failed to achieve a significant breakthrough, as high interest rates acted like an invisible hand suppressing the sector's performance.

Data source: Futubull. Data as of the close on July 19, 2024. The case is for illustrative purposes only and does not constitute any investment advice or guarantee.

Why would a rate cut be bullish for the biotechnology sector?

Biotech possesses dual attributes of both Pharmaceuticals and Technology, with companies in the pharmaceutical industry like Merck & Co and Eli Lilly and Co not fearing interest rate fluctuations, continuously reaching new highs, while technology stocks represented by NVIDIA and Microsoft are leading the entire market. Why do these two industries, when combined, make biotech companies more susceptible to interest rates?$Merck & Co(MRK.US)$,$Eli Lilly and Co(LLY.US)$,

Unlike larger pharmaceutical companies with stable cash flow, Biotech companies are mostly small to medium-sized enterprises. The business of Biotech companies can be significantly affected by the development of a single drug, and their cash flow is often unstable. Developing new drugs requires massive amounts of funding and time, and the probability of failure is high; historical data shows that about 90% of new drugs fail to gain approval.

During this period, biotech companies may remain unprofitable for long times, heavily relying on venture capital funds or going public on the Exchange to gain financial support.

It can be seen that funding is essential for biotech companies. Once the inflow of funds is lost, Biotech companies often fall into difficulties. And interest rates are a key factor affecting the cost of funds.

During periods of low interest rates, financing and mergers and acquisitions in the biotech field are often very active; even without external financing, companies can borrow at a lower cost to maintain daily operations. However, with the arrival of high interest rates, everything is reversed.

According to research agency Oppenheimer's statistics, during the loosest interest rate period in 2020, there were 245 financing events in the biotech industry; in 2021, when inflation began to show signs, there were nearly 200 events. However, in 2022, when the Federal Reserve started raising interest rates, biotech financing was directly halved, dropping to about 100. Although there was some recovery in the following two years, it has not returned to previous levels due to the effects of high interest rates.

How to invest in biotechnology stocks?

As the saying goes, "The spring river water warms the duck first," biotech companies that are very sensitive to interest rate changes often perform well around the onset of a rate cut cycle.

Morgan Stanley recently published a report that analyzed the historical correlation between rate cuts and the biotechnology sector. In the months leading up to the first rate cut, the biotechnology sector consistently outperformed the market, while its performance was poor in the month following the rate cut. After consolidating, biotechnology companies typically begin to rise again, usually increasing by about 20% to 30% within 6 to 12 months after the first rate cut.

Biotechnology stocks are generally smaller in scale, and there are many companies involved in the sector. The drug development process is quite complex, and company stock prices often experience significant fluctuations due to a single drug. Therefore, for the average investor, industry-related ETFs may be a better choice. Here are a few representative ETFs for reference:

IBB($iShares Biotechnology ETF(IBB.US)$) and XBI($SPDR標普生物科技ETF (XBI.US)$) are larger, each with nearly 8 billion dollars. ARKG($ARK Genomic Revolution ETF(ARKG.US)$) is an actively managed ETF under "Cathie Wood," also known as "Wood's Ark." LABU($Direxion Daily S&P Biotech Bull 3x Shares ETF(LABU.US)$) and LABD($Direxion Daily S&P Biotech Bear 3x Shares ETF(LABD.US)$) are leveraged ETFs, which are three times long/short. It should be noted that although leveraged ETFs can achieve excess returns, they can also amplify losses, and attention should be paid to the losses incurred during the running period.

Related Risks

• Interest rates have not declined as expected: Although the market currently seems to have the Federal Reserve's rate cuts 'set in stone', it cannot be ruled out that inflation may rebound in the coming months, leading the Federal Reserve to delay action. The biotechnology sector is likely to continue to return to a volatile market. The Federal Reserve will hold a meeting at the end of July and announce the interest rate decision on the afternoon of the 31st local time, so mooers should keep an eye on this.

• High volatility: R&D and clinical trial results, regulatory approval, market competition, and investor sentiment can all impact the performance of biotechnology companies. Companies within the sector also tend to have relatively small Market Caps, resulting in overall greater volatility.

Risk Disclosure: This content does not constitute a research report, is for reference only, and should not be used as the basis for any investment decision. The information contained herein is not a comprehensive description of the securities, markets, or developments mentioned. Although the sources of information are considered reliable, the accuracy or completeness of the above content is not guaranteed. Furthermore, there is no guarantee regarding the accuracy of any statements, viewpoints, or forecasts provided in this article.