Last week, the Federal Reserve delivered a mixed message that pushed the yield on the five-year U.S. Treasury to three-year highs. Stronger yields usually coincide with increasing economic growth prospects, which in turn could help the financial sector — and the Financial SPDR (XLF) — become the new market leader.
Click to Enlarge The fall season is generally bullish for stocks, as October usually delivers positive returns for investors. Over the past 20 years, the S&P 500 index has increased 65% of the time, by an average of 1.6%. The financial sector also has a seasonal upward bias, historically rising 60% of the time, at an average of 1.5%.
Last Wednesday, the Federal Open Market Committee completed its two-day monetary policy meeting. The Fed kept its statement unchanged and was careful to avoid any new language that would reveal a hawkish bias. Market participants were focused on a line in the statement that referred to the “considerable period” the Fed would wait until it began to normalize short-term interest rates.
What did change was the Feds’ forecast for future short-term interest rates. The “dot plot,” which shows the potential path of Fed fund interest rates in the future, increased slightly. That spilled over into the bond market, pushing prices lower (and thus yields higher).
The five-year Treasury yield broke out to new three-year highs, closing the week at 1.8%. Importantly, increasing medium- and long-term rates relative to short-term rates allow financial institutions such as banks to increase profit margins by borrowing from other banks at short-term interest rates and lending to customers at long-term interest rates. For example, a mortgage lender will see increasing margins as mortgage rates rise, while borrowing costs remain nearly unchanged.
There are a couple of ways you can take advantage of a potential rotation of investment capital into the financial sector.
If you are bullish on the direction of the broader market, this play is as simple as it gets. Simply buy the XLF, which hit a six-year high on increasing momentum. The XLF holds a host of bank, insurance and other financial stocks such as Wells Fargo (WFC), Berkshire Hathaway (BRK.B), American Express (AXP) and MetLife (MET), so by purchasing the XLF, you’re just making a broad, diversified bet that financials will go higher.
Click to Enlarge If you’re not so sure about the broader market, you’ll want a market-neutral way to take advantage of the potential outperformance of the XLF.
And to do that, you could enter a pair trade.
A pair trade is a strategy where you purchase one ETF and simultaneously sell short another ETF. The strategy is market neutral as it does not depend on the direction of the broader market and relies purely on the outperformance of the XLF relative the SPDR S&P 500 ETF (SPY).
The ratio of the XLF to the S&P 500 SPDR is 0.12. This compares to the 20-year low of 0.09 and the 20-year high of 0.27. The risk/reward on this pair trade is very favorable — you can risk 25% if the ratio returns back to the financial crisis lows at 0.09, relative to a return to the pre-financial-crisis highs (0.27), which would generate a return of more than 100%.
Additionally, there seems to be trendline support on the ratio near 0.11, which was the lowest ratio so far in 2014.
To initiate a pair trade on the XLF and the SPY, purchase the XLF, then either short the SPY, or purchase an inverse S&P 500 fund such as the ProShares Short S&P 500 ETF (SH).
As of this writing, David Becker did not hold a position in any of the aforementioned securities.
