Bank Stocks Continue To Disappoint; Broader Implications For Stocks Overall

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The first half of the year was disappointing for stock investors generally, with the major indices combining to give a 6-month performance that was essentially flat. Some were sectors more disappointing than others, perhaps the most being financials.

It is not that financial stocks did much worse than others, what with the SPDR Financial Sector ETF (XLF) down around a half a percent, but that they were expected to do much better. That such potential outperformance has failed to materialize means there must be something worrying investors about the sector.

The two things at the top of the minds of traders and investors in the first half have been trade wars and a rising interest rate environment. The expectation of outperformance in financials was based on the belief that both should have at worst a limited effect on bank stocks. While restrictive trade practices hurt everybody, they will not hit banks directly, and a strong argument can be made that a rising rate environment actually benefits the sector.

In theory, higher interest rates work in banks’ favor. A large part of their income is still derived from traditional banking practices like lending to individuals and businesses, and while low interest rates encourage borrowing, they also squeeze margins for lenders. Put simply, a bank making a loan at five percent makes less of a return than one lending at eight percent.

Obviously, it is not quite that simple, as banks also borrow and pay interest on deposits, but rising rates generally help profitability.

There is, however, one other thing to consider, the steepness of the yield curve.

The yield curve is a simple chart that plots interest rates on the vertical axis against the time to maturity of U.S. Treasuries on the other. Because investors generally seek a greater return the longer they tie up their money, that curve usually slopes upward from left to right. The steeper that slope, the greater the spread between short and long dated interest rates. As banks generally borrow in the short-term and lend in the long-term, the steeper the yield curve, the greater the potential profit.

The chart above (source: bondsupermart.com ) plots the yield curve one year ago on the yellow line against various times up to today on the red line. As you would expect in a rising rate environment, the whole curve has shifted upwards over the last year, but what is notable is that shift has not been even.

Once you get past bonds of about a 3-year maturity it is obvious that the curve has moved up less than for shorter dates, and by the time you get out to the 30 Year “long bond” there has been virtually no movement. The effect of that is to make the curve look flatter.

As stated above, that flatter curve presents a problem for banks. When you consider everything else that bank stocks have in their favor right now, that looks to be the reason investors are still showing caution about the sector. Recent stress test results were not perfect, but they showed decent stability in the U.S, banking system, and were good enough to allow for most banks to return capital through raised dividends and share buybacks.

Even with that, XLF has lost ground and the flatter yield curve is the most logical reason for that.

A flatter yield curve is not a good thing for banks, but it also is generally considered to be a bad sign for stocks in general. Higher interest rates prevail when the economy is strong, so a market that predicts relatively lower rates in the longer-term is effectively signaling an expectation of at best slow growth.

It is interesting, therefore, that the curve flattened even more on the latest hike, when the Fed sounded more concerned with the risks to growth than before. I said a few days ago that I saw a few signs that a correction was due, and this is another, more frequently observed metric that suggests the same thing. It could be a wild ride this summer!

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Stocks , ETFs , Investing Ideas , US Markets
Referenced Symbols: XLF

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