In one of this year’s most impressive laggard-to-leader stories, financial services exchange traded funds, including the Financial Select Sector SPDR (XLF) , are rallying on expectations that the Federal Reserve will raise interest rates for the first time this year later this month.
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.
Moreover, the financial sector received a boost from Presidential candidate Donald Trump after he proposed dismantling nearly all of Dodd-Frank, the package of financial reforms placed after the global financial crisis.
Although ETFs such as XLF and more focused plays, including the SPDR S&P Regional Banking ETF (KRE) , the largest regional bank-related ETF, along with the iShares U.S. Regional Banks ETF (IAT) and PowerShares KBW Regional Bank Portfolio (NYSEArca: KBWR ) , have recently been soaring, some analysts are forecasting more upside for bank stocks.
“I think what you’ll find is the bank stocks are still very inexpensive relative to the market. I think people are going to continue with this rally assuming, of course, the Fed raises rates, which we think could come in July,” RBC Capital Markets banking analyst Gerard Cassidy told CNBC on Tuesday.
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.
“When we look at the top 20 banks, we think it could positively impact their earnings by as much as 11 percent, if we get continuous rate increases through next year,” Cassidy told CNBC.
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Financial services firms, like capital markets, banks and regional banks, are among the top three industries with the highest sensitivity to changes in the 10-year Treasury yield. Over the past few years, financial stocks have underperformed the broader equities market as the Fed’s robust quantitative easing program and low interest rate policy caused the yield curve to flatten – a yield curve flattens when yields on long-term debt declines more rapidly than the yield on short-term debt, which causes a smaller spread between long- and short-term debt securities.
With interest rates poised to rise, financial services and banks could be in for an extended period of leadership.
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.