The Financial Select Sector SPDR (NYSEArca: XLF) and rival financial services exchange traded funds are receiving increased positive attention as advisors and investors come to grips with the fact that the Federal Reserve is likely to raise interest rates next month.
However, there is another important reason to consider bank stocks and ETFs: Rising profitability. In the case of regional banks, that profitability is expected to be enhanced if the Fed proceeds with boosting borrowing costs for the first time in nine years.
When it comes to higher interest rates bolstering financial services ETFs such as XLF, the good news is that the number of traders betting that the Fed will boost borrowing costs following its December meeting has climbed in recent days.
One point of attraction for XLF and rival financial services ETFs has been the discounted valuations of big bank stocks. However, the cheapness of U.S. banks belies the strength of the financial sector. Over few years, banks have shed unprofitable businesses and assets while bulking up capital to return some to shareholders through stock buybacks and dividends, the Wall Street Journal reports.
“U.S. banks earned $40.4 billion in profits for the third quarter, a 5.1 percent increase from a year earlier, the Federal Deposit Insurance Corp. said Tuesday,” reports Bloomberg. “Lower non-interest expenses were the main reason for the higher earnings in the three-month period that ended Sept. 30, the FDIC said in its quarterly report on industry performance. Reductions in costs tied to litigation outweighed weaknesses in operating revenue at large banks, the agency said.”
Another sign that cements the notion that investors are preparing for higher borrowing costs is the price action in the SPDR S&P Regional Banking ETF (NYSEArca: KRE). All KRE, the largest regional bank ETF has done over the past month is surge 7.5%.
A rising interest rate environment will throw a wrench into the financial markets. Nevertheless, bank-related exchange traded funds could weather the storm as financial firms have positioned ahead of the potential rate changes. KRE’s sensitivity to interest rates is well known. The ETF rose just 2% last year after surging 47% in 2013 when yields spiked. KRE’s holdings have an average beta of +0.44 to moves in the US 10 Year Treasury. [Look to Bank ETFs in a Rising Rate Environment]
“Of the 6,270 firms reporting third-quarter results, 59 percent had year-over-year earnings growth, the FDIC said Tuesday. The proportion of banks that were unprofitable declined to 5 percent from 6.6 percent a year ago and was the lowest since 2005, according to the agency,” according to Bloomberg.
Financial Select Sector SPDR
