Financials Struggling to Adjust to Flattening Rate Curve

From Mike Larson: As global markets attempt to digest the prospect of rising rates in the U.S., it pays to examine how the financials have been faring amid a flattening rate curve.

Did you see the 2012 movie “Trouble with the Curve”? If you’re a baseball enthusiast, a Clint Eastwood/Amy Adams fan, or just someone who likes a touching family drama, I highly recommend it.

The title refers to a baseball prospect who some scouts rank highly … but who Eastwood’s character (correctly) figures out can’t hit curve balls effectively. The prospect turns out to be a bust.

When it comes to the stock market, though, that title might apply better to banks. Investors have dog-piled into banks in the month of August amid increasing chatter of potential Federal Reserve rate hikes. The Financial Select Sector SPDR Fund (XLF) gained around 3.8%, while the interest rate-sensitive Utilities Select Sector SPDR Fund (XLU) dropped 5.8%.

The oft-repeated mantra on CNBC is that rate hikes are supposedly good for bank profits.

But there’s just one problem: It’s not whether rates rise or fall that truly matters for banks’ core lending and investing profitability. It’s HOW they move.

Banks like a steep yield curve. That’s because they make money by borrowing cheap funds from depositors or bond buyers at low short-term rates, then turn around and invest or lend that money at higher long-term rates. The wider the spread — or difference between the two — the better it is for banks.

You get a steep curve when all rates rise, but long-term rates rise faster and further than short-term rates. Or when all rates fall, short-term rates drop faster and further than long-term ones. Yet that isn’t what’s happening at all.

Take a look at this updated version of a chart I first shared with you last December. It shows the difference between 2-year yields and 10-year yields, a common measure of the steepness of the yield curve.



Click image for larger view

You can clearly see that the curve isn’t steepening at all. It’s flattening — and flattening massively. The 2-10 spread just sank to 0.75%, or 75 basis points, this week. That’s the lowest since way back to November 2007. The spreads between 2s and 30s, and 5s and 30s, have likewise collapsed to multi-year lows.

There’s a lot going on in the next few weeks. We have a G-20 summit, central bank policy meetings in Europe, the U.K., the U.S., and Japan, corporate earnings updates, and more. The markets could be in for one heck of a roller-coaster ride as a result.

But when I look at what’s happening, I can’t help but ask: Why would you want to own banks here?

XLF-2016-09-02

The Financial Select Sector SPDR Fund (NYSE:XLF) rose $0.07 (+0.29%) to $24.50 per share in morning trading today. The largest financial ETF has now risen 2.9% since the start of 2016.

This article is brought to you courtesy of Money and Markets.

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