Thursday, December 26, 2019

A Steeper Yield Curve Should Benefit Financial Stocks

In 2018 the Federal Reserve pursued an interest rate policy the led to the yield curve (10y/2y) inverting. This year the Federal Reserve Bank has reduced the Fed Funds rate three times in response to a slowing economy that developed in 2018. The last 25 basis point rate cut occurred in October and some now believe this may be the last cut of this cycle. Coinciding with the last cut was a paper released by the San Francisco Fed that discussed the economic growth benefit of pursuing a negative interest rate policy. One outcome of a lower rate, flatter yield curve policy is the fact banks have difficulty earning an adequate spread on their loans. Now that the Fed seems to be on hold for the moment, and an economy that seems to be improving, the yield curve has begun to steepen with the 10-year Treasury yield rising nearly 30 basis points to near a 2.0% yield. The below chart shows the yield curve from six months ago (red line) to today (green line.) Clearly, the curve has steepened from six months ago.

With a yield curve that is now steepening, financial stocks should benefit in this environment. Since the yield curve uninverted at the beginning of September, the performance of the financial sector has outpaced the performance of the broader S&P 500 Index. If the curve continues to steepen on the back of improved economic data, this would be one tailwind for financial sector performance relative to the broader market. The upward trending blue line in the below chart represents the financial sector outperforming the broader S&P 500 Index.

One last characteristic of the financial sector is the fact it is trading at a lower valuation compared to the other S&P 500 Index sectors. The PEG ratio is elevated; however, financial earnings could get a boost with the steeper yield curve that should lead to better earnings on asserts such as loans.

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