The Financial Select Sector SPDR (NYSEArca: XLF), the largest financial services ETF, is lower by 3% over the past month, but some market observers believe the sector warrants renewed attention in the current interest rate climate.
Earlier this year, financials were also propped up by a rise in bond yields as higher interest rates typically widen the margin spread between bank loans and deposits. The spreads will further widen as the Federal Reserve has stated its intentions to raise interest rates in response to economic growth and rising inflation.
A steeper yield curve could help XLF and rival financial services ETFs rebound.
“Banks get squeezed as a yield curve flattens, since they typically take on short-term debt to fund longer-term loans, and profit from the gap between the two rates. Conversely, a steeper yield curve would boost the margin,” reports Evie Liu for Barron’s.
Looking for Financial Catalysts
Fundamental factors, including the aforementioned rising interest rates, have been supportive of bank stocks and ETFs this year. Additionally, the financial services sector, the second-largest sector weight in the S&P 500, has had the regulatory wind at its back this year as the Trump Administration has sought to roll back parts of the Dodd-Frank legislation. Still, the sector is disappointing investors.
Canaccord Genuity’s Tony Dwyer “wrote that financials bottomed in relative performance when the yield curve reached about 35 basis points–that’s where it stands currently–for both the 1990s and 2000s cycle. The sector actually outperformed the market from that point on as the curve flattened some more, until it inverted, going into the negative numbers,” according to Barron’s.
Flatter yield curves means the cost of long-term debt is falling faster or not growing as quickly as the cost of short-term debt. Historically, flat yield curves have been reliable indicators of looming recessions.
Canaccord Genuity’s Dwyer “pointed out that even though every recession in the past 60 years has been preceded by an inversion of the curve, it takes an average of 18.5 months to reach the cycle peak from the initial date of inversion and the S&P 500 has realized a median gain of 21% during that time period,” reports Barron’s.
For more information on the banking sector, visit our financial category.