ETF Trends
ETF Trends

The Federal Reserve raising interest rates for the first time in nearly a decade last month and expectations for several more rate hikes this year are viewed as positive catalysts for many financial services stocks and exchange traded funds, but the near-term outlook for the sector is clouded due to a flattening yield curve.

Prime rates are the interest rates that commercial banks charge credit-worthy clients and are typically determined by the federal fund rate, or overnight rate that banks lend to one another.

Major banks hiked their prime rates in response to the Fed’s decision to raise its main short-term rate to a range of 0.25% to 0.5% from its previous range of 0% to 0.25%.

However, these banks have held off on raising the deposit rates, or the interest rate banks pay to account holders. The average interest rate on a savings account is about 0.48%, according to Bankrate.

The wider discrepancy between deposit and prime rates could translate to improved profit margins and a potentially stronger financial sector ahead. [Bank Sector ETFs Could Lead as Rates Rise]

More pressing is recent price action in financial services stocks and ETFs, which highlights the group’s vulnerability to a flattening yield curve.

“But by December, even before the Fed actually raised rates, conditions changed. Banks stocks were lagging again and the spread, or difference, between the yield on the 10-year Treasury note and the two-year Treasury note – called the 10-2 or 2-10 spread – shrunk to the extremely narrow levels seen in July 2012 and February 2015,” reports Michael Kahn for Barron’s.

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.

“The problem with a flat yield curve is that it usually appears when the economy is heading toward recession. The details are outside the scope of this column, but it is safe to say that a flatter yield curve would be bad for bank lending. And since financial stocks make up about 16% of the Standard & Poor’s 500, weakness in that sector would create a serious drag on the stock market from a technical point of view,” adds Barron’s.

Financial Select Sector SPDR

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.