Financial stocks battered as yield curve flattens

Global equities are once again opening the week on the back foot as a joint story from the Wall Street Journal and Bloomberg further exacerbated US-China trade tensions.

Global equities are once again opening the week on the back foot as a joint story from the Wall Street Journal and Bloomberg further exacerbated US-China trade tensions. The report alleges that the US will increase scrutiny of Chinese investments in certain US industries deemed critical to economic and national security.

This morning, US Treasury Secretary Mnuchin tweeted that the report was “false, fake news” (the next mutation of the #fakenews epidemic?), but seemingly confirmed a very similar policy was in the works. Stock traders have opted to “sell first and ask questions later,” driving the Dow Jones Industrial Average down over 400 points midway through the trading day, with the tech-heavy NASDAQ Composite falling by more than 2.5% as of writing.

While today’s big drop in the market-leading technology sector is noteworthy, we wanted to take a close look at the second-largest US sector by market capitalization, financials. With interest rates generally rising through the first half of the year, a naïve analysis might suggest that financial stocks (which, after all, often make money by lending funds at the prevailing interest rate) should be big beneficiaries. In actuality, financials are among the worst-performing sectors year-to-date:



The explanation for this counter-intuitive phenomenon lies with the yield curve, or the difference between short- and long-term interest rates. While it’s true that interest rates have risen across the curve in the US, short-term rates have risen far more dramatically as the market adjusts to a more hawkish Federal Reserve. By contrast, longer-term interest rates, which vary based on the market’s expectation for long-term growth and inflation, have been relatively stationary.

The upshot is that the yield curve has flattened dramatically over the last 18 months. For example, the 2yr-10yr spread has fallen from about 130bps at the beginning of 2017 to 54bps at the beginning of 2018 to 34bps (0.34%) now. Banks and other financial institutions that make profits borrowing short-term funds (through products like savings accounts and CDs) and lending out funds over a longer-term horizon (through business, auto, and mortgage loans) may now expect their profits to fall. As a result, financial stocks continue to underperform the broader market.


Source: FRED

Moving forward, investors should keep a close eye on the yield curve, both for its impact on financial stocks and its historic propensity to invert (when short-term rates rise above long-term rates) before economic recessions. With the widely-followed 2-10 spread now just a third of a percent away from that threshold, traders of all stripes are sitting on the edges of their seats.  

Disclaimer: The information on this web site is not targeted at the general public of any particular country. It is not intended for distribution to residents in any country where such distribution or use would contravene any local law or regulatory requirement. The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency or CFD contract. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. Any references to historical price movements or levels is informational based on our analysis and we do not represent or warranty that any such movements or levels are likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness, nor does author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.

Futures, Options on Futures, Foreign Exchange and other leveraged products involves significant risk of loss and is not suitable for all investors. Losses can exceed your deposits. Increasing leverage increases risk. Spot Gold and Silver contracts are not subject to regulation under the U.S. Commodity Exchange Act. Contracts for Difference (CFDs) are not available for US residents. Before deciding to trade forex and commodity futures, you should carefully consider your financial objectives, level of experience and risk appetite. Any opinions, news, research, analyses, prices or other information contained herein is intended as general information about the subject matter covered and is provided with the understanding that we do not provide any investment, legal, or tax advice. You should consult with appropriate counsel or other advisors on all investment, legal, or tax matters. References to or GAIN Capital refer to GAIN Capital Holdings Inc. and its subsidiaries. Please read Characteristics and Risks of Standardized Options.

Open an Account