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A flattening yield curve has reportedly forced the Goldman Sachs strategy team to recommend closing its U.S. bank stock recommendation, one of the most profitable trade ideas of the past twelve months. The U.S. yield curve remains the primary driver of bank stock performance and further flattening will form a major hurdle for investments in the sector.
The first chart (also at left) shows how important the interest rate environment has been for U.S. bank stocks (correlation is 0.90). The steepness of the Treasury curve (the difference in yield between the 10-year and two-year bonds) has been a better predictor of performance than earnings, balance sheet improvement or price-to-book ratios.
The sector benefited from a steepening curve between April, 2013, and mid-August. This makes sense in that core business of banks is "borrowing short and lending long" – the rising difference between short and long rates increases profits on new loans.
Recently, however, the curve began flattening in a sign that the rate jump in 10-year bonds might have been a bit overdone. Bank stocks reacted immediately, falling 6.7 per cent from then until Wednesday.
Ten-year rates should continue to fall as long as U.S. economic data falls short of expectations. (For those with access, the Citigroup U.S. Economic Surprise Index is the best way to follow that trend.) Weaker data will depress long-term yields, flattening the curve and pressuring U.S. bank stocks.
A flatter curve also threatens a trade of particular interest to Canadian investors. Bank of America strategist Michael Hartnett recommended selling Canadian banks/buying U.S. banks in early 2013. The second chart (second left) shows the ongoing performance of this trend (both indices indexed to 100 at beginning of year and S&P/TSX Bank Index converted to U.S. dollars). The advantage remains with U.S. banks but strong relative gains for the TSX bank index are closing the gap quickly.
Canadian investors that added U.S. bank exposure earlier in the year should pat themselves on the back, then take some profits. I still think, in general, U.S. dollar assets are a good idea for domestic investors. But until there are signs that the U.S. yield curve has resumed steepening, U.S. bank stocks are no longer part of the theme.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.
Scott Barlow