Skip to main content

Tourists walk past a Bank of America banking centre in New York in this June 22, 2012 file photo. The U.S. government on August 6, 2013, filed two civil lawsuits against Bank of America for what the Justice Department and securities regulators said was a fraud on investors involving $850-million (U.S.) of residential mortgage-backed securities.Brendan McDermid/Reuters

There's no mystery behind the recent weakness in the U.S. bank sector: stock prices continue to track the steepness of the U.S. yield curve.

U.S. banks were among the few sectors hoping that the Fed would withdraw monetary stimulus. The threat of tapering pushed ten-year Treasury bond yields sharply higher and made the yield curve steeper. Since banks specialize in borrowing at short-term rates and lending the proceeds at long-term rates, the steeper curve signalled higher profits, and bank stocks climbed.

This chart shows what happened when the Fed decided not to decrease its stimulus – the yield curve flattened and bank stocks dropped. The yield differential between ten year bonds and two year bonds fell almost 20 basis points and the KBW Bank Index eased three per cent.

The relationship between curve steepness and bank stocks has been extremely close for the past year. (For the mathematically inclined, the r-squared is 0.81.) There will come a time when another factor – valuations, for instance – will matter more, but recent stock performance in the sector has been remarkably predictable.

For traders, the correlation between curve steepness and bank stocks does appear strong enough to play – owning bank stocks when the curve is steepening and selling them when flattening – and the KBW Bank ETF would seem the logical vehicle. They should, however, keep their stops tight in case the correlation fades.

Investors in U.S. bank stocks should be aware that a flattening yield curve is a difficult hurdle for bank stocks to overcome. Performance is likely to be weak as long the curve is flattening, but a renewal of tapering fears or an increase in inflation pressure – anything that pushes ten-year yields higher – would have positive effects.

Follow related authors and topics

Authors and topics you follow will be added to your personal news feed in Following.

Interact with The Globe