As yields stabilize, banks benefit
An overlooked sector, despite recent rate-hike speculation, has been the financials. They are one of the prime beneficiaries of a move higher in rates. As longer-term rates move up, they can charge more to lend.
Typically, when long-term rates are moving higher, short-term rates are doing the same. However, short-term rates do not tend to move up as quickly, causing the gap between long- and short-term rates to widen. And financial institutions see the spread between their cost of funds and what it costs to borrow their funds increase. This is known as Net Interest Margin (NIM).
NIM is an important gauge for investors because it’s an indicator of a bank’s health. When NIM is contracting, it usually has negative implications for profits and cash flow. When NIM is expanding, this portends increasing profits and cash flow.
The London Interbank Offered Rate (LIBOR)/Overnight Indexed Swaps (OIS) spread is another important financial gauge to follow. It indicates levels of stress in U.S. money markets. Recent tax-law changes increased Treasury issuance to meet new budget needs. It also drove large corporations to shift offshore dollars from bonds into cash. This drove the yields for shorter-duration debt instruments higher.
As a result, spreads between short duration and long duration debt compressed – also known as a flattening of the yield curve. A flattening yield curve hurts a bank’s ability to increase NIM. The move higher in banks’ borrowing costs eats away at their margin. In late March, money markets were showing signs of stress not seen since the euro crisis in 2012…
And financials paid the price.
From the time the LIBOR/OIS spread began rising at the end of January to the time when the spread began to show a meaningful pullback at beginning of this month, the Financial Select Sector SPDR Fund (XLF) had dropped roughly 12.3%.
Now as inflation and economic concerns have begun to ease, the LIBOR/OIS spread is doing the same. Recent U.S. economic data has indicated domestic growth is on the rise while regional data in Europe and Asia are showing signs of moderation.
At the same time, Federal Reserve officials are telling us they are willing to let inflation overshoot their 2% target since it undershot for so long. This should help ease signs of stress in U.S. money markets as yields stabilize. In turn, that should imply a firming NIM, boosting the financial sector’s appeal.
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