When analysts discuss the “financial sector,” they are often too general about what kinds of stocks they are referring to within the sector.
In the broadest terms, the sector includes banks, brokers, insurance companies, real estate investment companies, business development firms and credit card companies, which is a fairly broad spectrum of different kinds of business activities to lump together.
However, there are some very important similarities between all of these firms that probably justify being grouped together like that. Besides the fact that these firms primarily offer financial or investment services, they also share important sensitivities to interest rates and the bond market.
Two of the issues that have been plaguing the financial sector over the last few years are related to low interest rates.
First, most of the firms within the sector make money off of the interest-rate spread. Large financial firms have a lower cost of capital than what they make when they invest or loan that capital out. Second, most financial firms are very sensitive to stability in the bond market. Low interest rates are initially really good for bond prices, but that benefit doesn’t last.
As you can see in the next chart of the SPDR Banking ETF (NYSEARCA:KBE), these stocks haven’t seen any gains since the beginning of 2014. Price moves to the downside have also been much larger than what is normal as well.
Understanding why these companies are sensitive to interest rates and the bond market will help explain a lot of the volatility we can see in the prices.
If financial companies make money from the difference (or spread) between their costs of capital and what they can earn from investing or loaning that money, then lower spreads are a bad thing for profits. Spreads are very low right now because of the Federal Reserve’s virtually-zero-interest-rate policy (ZIRP), but the Feds intervention has also kept spreads from being very volatile.
A smooth spread trend has helped financials to regain profitability after the financial crisis, but its low level has also reduced these companies appetite for risk and growth opportunities.
If interest rates rise this year, many of these firms will benefit, but it may be more uneven than many investors assume because of the second issue caused by low interest rates — falling bond prices.
Instability in the Bond Market
If everything else is held equal, the same move up in interest rates has a much more negative effect on bond prices than an equivalent downward interest-rate move will help bond prices. In fact, if market interest rates rise unexpectedly (as many Fed members fear), then the negative effect on bonds could be catastrophic.
A large move seems unlikely to us, which seems to be the broad consensus, but the probability is still high enough to make investors, banks and managers nervous.
Keep in mind that the credit crisis of 2008 was triggered by a sudden collapse in a specific kind of bond that represented a fairly small component of the total debt market. Even if such a move is unlikely to happen in the near term, its remote possibility is enough to make investors cautious.
At this point, bond prices are so high (because yields are so low) that there is virtually no other direction left to go. Interest rates can go negative but only if the dollar continues to appreciate, which would bring on another set of very serious problems. The stability of the entire financial sector depends on a stable, slow, reliable increase in interest rates.
That is the Fed’s plan, but it’s also a bit of a tight rope.
Why Does it Matter?
You could think about financials as the heart of the economy that is pumping blood (or capital) to the rest of the companies out there. If financials are lagging, we would expect the market to follow. Similarly, if volatility in the financial sector increases, we would expect volatility to increase across the board.
So far this year, financial firms have seen returns that are somewhere in the middle of the pack compared to other sectors. There have been gains, but the environment isn’t like it was in 2013 when financial firms dragged the rest of the economy up with them.
To be clear, we aren’t bearish on financials, but we are seeing signs that uncertainty is rising, which will probably keep a lid on further gains within the sector. If we are right about that, the typical result is for the rest of the market to flatten out and experience increased levels of volatility.
So far, that has been the pattern in 2015, which is unlikely to change until investors grow more comfortable with the Fed’s rate hikes.
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