The global financial markets are driven by expectations. Traders ask themselves questions like: “How strong is the economy going to be in six months?,” “Are corporate earnings going to be strong?,” “What are interest rates going to look like down the road?” They then place their trades based on what they expect the answers to these questions will be.
One of the key metrics traders are focusing on right now is expected interest rates. The Federal Open Market Committee raised the federal funds rate in December from a range of 0% to 0.25% to a range of 0.25% to 0.50%. Now the big question is, “When will the FOMC raise rates to a range of 0.50% to 0.75%?”
So how do we gauge market expectations for when and how quickly the FOMC will be raising interest rates in the future? Do we have to conduct surveys to find out what investor sentiment is? Mercifully, we don’t have to do that.
There are actually futures contracts that track expectations for the FF rate that we can follow. The benefit of being able to track an asset instead of a sentiment survey is that traders have to put their money where their mouth is when they buy or sell a futures contract, whereas they can say whatever they want when responding to a survey.
Traders use the 30-day FF futures contracts to hedge against, or speculate on, potential changes in the FOMC’s monetary policy. The price of each contract represents what traders believe the average daily effective FF rate is going to be for a given calendar month. You can see what traders believe the effective FF rate is going to be by subtracting the price of the contract from 100.
For example, you can see in Fig. 1 that the price of the June 2016 contract is 99.6325. If you subtract this number from 100, you will see that traders anticipate that the effective FF rate is going to average 0.2675% during the month of June. That fits perfectly within the 0.25%-0.50% range the FOMC set in December.
Based on the numbers in Fig. 1, traders don’t believe we are going to see the average FF rate rise above 0.50% until December of 2016 (100 – 99.470 = 0.53).
This sentiment is confirmed by the CME Group FedWatch tool, which doesn’t put the probability of a rate hike above 50% until the Dec. 14 FOMC meeting (see Fig. 2).
While this has been good news for those who want interest rates to remain lower for longer, it hasn’t been great news for the financial sector.
Financials and a Flatter Yield Curve
With expectations for a rate hike being pushed further into the future, the yield on longer-term Treasuries is also dropping, and this is flattening the yield curve.
You can see this illustrated by comparing the yield on the 10-year Treasury with the yield on the 2-year Treasury. The chart in Fig. 3 plots the yield difference (10-year yield minus 2-year yield) between these two Treasuries.
When the yield curve is steeper, the difference between the yield on the 10-year Treasury and the yield on the 2-year Treasury will be higher. When the yield curve is flatter, the difference between the yield on the 10-year Treasury and the yield on the 2-year Treasury will be lower.
As you can see in Fig. 3, the difference between the yield on the 10-year Treasury and the yield on the 2-year Treasury has been getting lower and lower since early 2014, which means that the yield curve has been getting flatter and flatter.
Flat yield curves are bad news for financial firms, like banks, because they derive a large portion of their revenues from the difference between short-term yields and long-term yields. The revenues banks make by paying depositors short-term rates while charging borrowers longer-term rates is called net-interest margin.
When the yield curve flattens, net interest margins get compressed. You can see this illustrated in the chart showing Net Interest Margin for all U.S. Banks in Fig. 4.
This is a trend we don’t see reversing anytime in the immediate future.
While financial stocks may get dragged higher by the bullish market forces at work right now, they will most likely continue to underperform.
You can see in the relative-strength comparison chart of the Financial Select Sector SPDR Fund (XLF) versus the SPDR S&P 500 ETF Trust (SPY) in Fig. 5 that XLF has been underperforming SPY during the bullish breakout in June.
Fig. 5 — Daily Relative-Strength Chart Comparing XLF and SPY
We expect this trend to continue.
InvestorPlace advisors John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.
