Despite calls for higher interest rates, a flattening yield curve could diminish the profitability for the banking industry and weigh on financial stock-related exchange traded funds.
Year-to-date, the Financial Select Sector SPDR (NYSEArca: XLF), which includes a 36.0% tilt toward the banks sub-sector, has increased 12.5%, while the SPDR S&P Regional Banking ETF (NYSEArca: KRE) was up 0.2% and the SPDR S&P Bank ETF (NYSEArca: KBE) was 0.7% lower.
Once the Federal Reserve eventually hikes rates, yields and bank net-interest margins would move back toward normal levels, which would help provide a nice boost in bank valuations, writes David Reilly for the Wall Street Journal.
Short-duration bonds and money market funds have already seen yields rise, suggesting that the markets are pricing in higher rates ahead. Despite dipping slightly over the past few days, short-term U.S. interest rates remain at or above year-ago levels, with 2-year Treasury yields at 0.61%. [Short-term, Money Market Bond ETFs Reveal Rising Rate Expectations]
However, long-term yields have dipped, with benchmark 10-year Treasuries falling below 2% Tuesday to as low as 1.889%. Dragging on long-term yields, foreign central banks are engaging in monetary easing, which has pushed investors into more attractive income-generating assets like U.S. Treasuries. [Investors Can’t Get Enough of Treasury Bonds, ETFs]
“The buying has been orderly and there has been demand from investors including some deep-pocket foreign central banks and money managers.” Jason Rogan, managing director of US government bond trading at Guggenheim Securities LLC. said in a Wall Street Journal article.
The spread between 2- and 10-year Treasuries has contracted to about 1.3 percentage points, its lowest since late 2012. Consequently, the financial sector may see profitability decline as the difference between what banks make by borrowing and lending money shrinks.
The banking industry will likely experience greater gains once short- and long-term rates rise in tandem. The sector, though, could still find strength on an improving economy, expanding jobs and rising spending due to lower gas prices, which could all add to loan growth. However, without a favorable yield outlook, we could experience another tepid year for bank stocks.
Financial Select Sector SPDR
For more information on the banking industry, visit our financial category.
Max Chen contributed to this article.