Been noticing the flattening of the North American yield curve. The yield on mid-term US Treasuries climbed above 3.9% last week. That on the back of tepid demand at auction for 10-year Notes.

That’s important to the US housing market, because mortgage funds key off the 10-year rate. Traders should be concerned, according to some analysts, if yields on 10-year Notes move above 4%. Especially near term, when the US Federal Reserve is unwinding support for the mortgage market. Take collectively, these twin events could pose a real threat to the US housing recovery. Assuming of course, the US housing market is really in recovery!

At the very least, a flattening yield curve implies a near term pause in the outperformance of equities versus bonds. Higher rates increase borrowing costs for corporations, which negatively impacts earnings.

Dealing with this risk scenario, bullish traders might want to focus on companies and sectors that are typically, less vulnerable to changes in the rate structure. Sectors that come to mind include materials, oil and technology.

That’s not to suggest these sectors are immune to rate hikes. Rising interest rates typically slow consumer demand which, on a macro level, impacts GDP. Still there remains an insatiable desire for raw materials like base metals and oil. Which makes them less vulnerable to rising rates.

The technology sector is about leverage as opposed to insatiable desires. In a rising rate environment, leverage is bad. But, companies, like Research In Motion that are flush with cash, can actually boost their balance sheets with a rise in rates.

Typically, financial companies feel the biggest pinch from rising rates. The classic example is banks, whose margin hinges on the spread between what they pay for capital and what they can lend that capital out at. And while higher rates might not necessarily impact the margin, it does impact the creditworthiness of customers, effectively diminishing the number of potential borrowers.

Given the current environment, aggressive traders might look at bullish positions on companies that will be least impacted by rising rates. And perhaps, take bearish trades on companies that will be negatively impacted by rising rates.

So what strategy makes the most sense? Well, as we have been saying in this column for the past couple of weeks, option premiums are at the low end of their range. Which is to say options are relatively inexpensive. So option buying strategies remain the strategy of choice.

Bullish traders might look at buying calls on stocks like Canadian Pacific Railway (TSX: CP, recent price $55.70), Suncor Energy Inc. (TSX: SU, $30.85), or CGI Group Inc. (TSX: GIB.A, $15.33). With Canadian Pacific, look at the CP Oct 56 calls at $3.40. In the oil sector, the Suncor Sept 32 calls at $1.80 look interesting. And within the information technology sector, GIB November 16 calls at $1.00.

Conversely, bank stocks and utilities are more vulnerable to rate hikes, which typically implies bearish option strategies. However, and maybe it is just me, I can’t help but think that any downturn within the financial sector, will be cushioned by the dividend yield on the Canadian banks. More to the point, I believe the dividends being paid by the big five Canadian banks are solid and might actually rise before year end.

With that in mind, I would prefer holding the banks and collecting the dividends. If you think the upside may be limited in a rising rate environment, you could look at writing in-the-money covered calls.

While covered call writing is not a bearish trade, it does offer some downside protection at the cost of limited upside potential. For example, with Bank of Montreal (TSX: BMO, $61.84), you could buy the shares and write the October 60 calls at $3.45.

This covered write provides some downside protection. Downside break even not including dividends is $58.39. Of course your upside is also limited but, unless the calls are assigned early, you will collect two healthy dividends from BMO between now and the October expiration.