Financial services exchange traded funds, including the Financial Select Sector SPDR (NYSEArca: XLF) and the SPDR S&P Bank ETF (NYSEArca: KBE), remain beholden to the whims of the Federal Reserve.
Over the next couple of months that might not be a bad thing, particularly as markets price in increasing odds that the Fed will finally raise interest rates in December.
Heading into this year, many market observers expected four Fed rate hikes, a number that subsequently dropped to two and now, in the eyes of some experts, zero. Higher interest rates would help widen the difference between what banks charge on loans and pay on deposits, which would boost earnings for the financial sector.
SEE MORE: Bullish Signs for Bank ETFs
With a steepening yield curve or wider spread between short- and long-term Treasuries, banks could experience improved net interest margins or improved profitability as the firms borrow short and lend long.
Some market observers see the second-largest sector allocation in the S&P 500 as being a valid bullish play for the last three months of the year.
“The prospect of a December interest rate hike (and higher interest rates, in general) is reflected by the shift in leadership in the equity markets. Defensive sectors like gold, real estate and utilities have given way to the technology, energy, materials, and industrial sectors that are more closely tied to the performance of the economy. The financial sector moved into the top five in relative strength. A strong financial sector has leading and bullish implications for the stock market longer term,” according to See It Market.
Financial entities like banks will benefit from expanding margins as rates climb. A rising rate environment may reflect a strengthening U.S. economy, and a healthier economy would help borrowers have an easier time repaying loans, with banks stuck with fewer non-performing assets. Moreover, rising rates means that banks will generate greater revenue from the spread between what they pay deposit savers and the prime rates they charge credit-worthy clients and other highly-rated debt.
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After parting ways with real estate, ETFs like XLF are now more heavily allocated to traditional banks and insurance providers, companies that positively correlated to rising interest rates.
“The fed funds futures market discounts the probability of a November federal reserve interest rate hike but puts the odds of a December interest rate hike at 66%. Stocks are likely to remain range bound with the risk to 2120 and reward to 2190 using the S&P 500 Index,” reports See It Market.