Financial services exchange traded have recently been buoyed by rising Treasury yields and speculation that the Federal Reserve is set to boost interest rates, but history could prove to be a guide for what investors should expect from the sector when rates actually do rise.
Rising Treasury yields have been a driving force behind financial services sector ebullience. Put simply, interest rates play a significant role in investors’ attitude toward bank stocks and ETFs. Investors are responding by pouring into ETFs such as the Financial Select Sector SPDR (NYSEArca: XLF).
“During the last three Fed Funds rate increase cycles, bank stocks underperformed the stock market. Increases in the Fed Funds rate led to higher borrowing costs (rates paid on deposits), while loan yields were stable, thus squeezing bank lending margins. During three of the last four rate hikes, shares of U.S. banks significantly underperformed the broader stock market, starting an average of two quarters before the first rate hike. However, once the Fed was done hiking rates, bank stocks outperformed the broader market,” said S&P Capital IQ in a new research note.
The research firm believes this tightening could be different with XLF and friends playing leadership roles into a Fed rate hike. That scenario is already playing out. The SPDR S&P Regional Banking ETF (NYSEArca: KRE), the largest regional bank ETF, climbed 5.3% in June and resides near eight-year highs. The SPDR S&P Bank ETF (NYSEArca: KBE), which allocates over three-quarters of its weight to rate-sensitive regional bank stocks, is up 4.5% over the past month.
Bolstering the outlook for bank stocks, the strong May employment numbers fueled speculation that the Fed would hike rates this year in response to the improving economic outlook. [Look to Bank ETFs in a Rising Rate Environment]
“The 17 rate hikes of 0.25% each in the time period 2004/06 raised the Fed funds target rate from just 1.00% in June of 2004, to 5.25% by mid-May of 2006. In this time, the spreads between the 10-year US Treasury and the 3-month Treasury narrowed, from 3.32% at June 29, 2004, to negative 0.60% in early 2007. The narrowing of the spread was due to the 10-year remaining in a tight range of about 4.0% to about 5.25%, while the yield on the 3-month rose from 1.0% to 5.0%, thus narrowing the spread to zero, and then to negative,” according to S&P Capital IQ.
KRE’s holdings have an average beta of +0.44 to moves in the US 10 Year Treasury. In June, investors added over $1 billion to XLK, nearly $652 million to KRE and $237.3 million to KBE.
“Once the Fed finished rate increases, and the broader economy responded with higher GDP and loan growth, bank stocks significantly outperformed the S&P 500. Banks reflected these economic improvements by registering higher loan growth. Net interest income growth was also strong, due to wider NIMs,” notes S&P Capital IQ. [Good Tidings for Bank ETFs]
S&P Capital IQ has overweight ratings on KBE and KRE.
SPDR S&P Bank ETF
Todd Shriber owns shares of XLF.