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Changes in Fed Rates Will Weigh on Financial Stocks, ETFs

This article was originally published on ETFTrends.com.

Many have pointed to changes in long-term interest rates as a major selling point for the financial sector and related ETFs, but there is more to the picture.

The financial sector has enjoyed a good run as yields on long-term debt increased, but the good times are starting to peter out as the Federal Reserve tightens its monetary policy. The Financial Select Sector SPDR (XLF) , the largest  financial services-related ETF, has dipped 1.5% year-to-date while the S&P 500 rose 5.2%.

David Ranson, director of research at financial-research firm HCWE & Co., argued that bank stocks have been more historically sensitive to changes in short-term rates than long-term rates, the Wall Street Journal reports.

Looking at annual data from 1989 through 2015, Ranson found bank stocks rallied 14.2% on average in the two years following cuts in the fed-funds rate, compared to the average 7.4% gains in the two years following a hike in the fed-funds rate. Additionally, while bank stocks increased 11.5% in the two years after yields declined, the sector saw 10.5% gains in the two years following an increase in yields.

Furthermore, loan volume and interest rates paid to depositors also play a role in a bank's bottom line. Banks boost profits by increasing loans even if profit margins are low.

Related: Earnings Season Friday for J.P. Morgan, Wells Fargo, Citi, PNC

Loan Growth Starts to Trend Higher

According to a Goldman Sachs report, “loan growth has started to trend higher,” meaning the rate at which the banks are making new loans is accelerating.

What banks pay depositors also affects profits. If rates paid on deposits rise faster than those charged on loans, higher yields on loans wouldn’t result in higher profit margins.

“Eventually the deposit rate will start to rise,” Mayank Seksaria, head of macro strategy at New York-based Macro Risk Advisors, told the WSJ.

“We might have reached peak margins for this cycle,” Seksaria added. He also doubts that loan growth will surge the way it has previously. “It won’t pick up in a way consistent with prior cycles.”

For more information on the financial sector, visit our financial category.