A new divergence has opened up in U.S. markets that may result in renewed selling pressure on sluggish Canadian bank stocks.
A limited number of foreign hedge funds have been shorting Canadian bank stocks and using the proceeds to buy U.S. banks since this strategy was listed among the trades of the year by Merrill Lynch in 2015. The initial popularity of the trade pushed domestic bank short positions to record levels by the end of 2016.
The short positions on Canadian banks (as a percentage of the total stock float) have fallen significantly since that point as the accompanying top chart indicates. In the case of Toronto-Dominion Bank, for instance, the short positions went from 4.5 per cent of the float at the end of 2016 to the current 2.3 per cent.
The middle chart shows how well the Merrill Lynch trade would have worked if implemented when they recommended it at the beginning of 2015. In Canadian dollar terms, an investment in the KBW U.S. bank index would have been valued at $15,675 as of Friday’s close, for a cumulative gain of 57 per cent. The same investment in domestic banks would have returned a much smaller $12,172 or 22 per cent return. (Dividends were not included for either index for data reasons.)
For an investor who shorted Canadian banks to buy U.S. banks when Merrill Lynch suggested, the current profit would be 35 per cent or $3,503. This represents the difference between the cost of buying back the Canadian bank short position ($12,172), and the value of the U.S. bank index investment ($15,675).
Despite their outperforming domestic banks, Goldman Sachs believes that U.S. banks remain undervalued in light of rising U.S. bond yields.
The bottom chart, recreated from Goldman Sachs research, compares the relative performance of U.S. bank stocks (compared with the broader S&P 500) and 10-year U.S. Treasury yields. In the former case, I divided the value of the KBW Bank Index by the S&P 500 (we are only watching the trend here, the level is irrelevant). A rising burgundy-coloured line indicates that banks are outperforming the benchmark.
The chart highlights that U.S. bank stocks have generally outperformed as yields rise. Banks are one of the few sectors that benefit from higher longer-term yields because the basic business of lending involves banks borrowing funds at low short-term rates, and lending them to customers at longer-term rates. Higher longer-term rates generate more profits from lending.
However, since December, 2017, the chart shows U.S. bank stock prices have not followed 10-year Treasury yields higher and this is a major reason why Goldman Sachs believes they are set to rally.
Putting the three pieces of the puzzle together, short positions on Canadian banks are down from peak levels, domestic bank stocks are underperforming U.S. banks and U.S. bank stocks are undervalued, at least according to Goldman Sachs.
I am not making any predictions about the future relative performance of Canadian and U.S. banks here – domestic investors’ faith in our banks has been amply rewarded over the long term.
But it would not surprise me if foreign hedge funds renewed the trend of shorting major Canadian banks and buying their U.S. counterparts. Recent performance trends, the potentially undervalued U.S. bank stocks and increasing signs of the end of the domestic housing price rally make the trade more attractive.
If this occurs, and admittedly it’s a speculative scenario, the selling pressure of new short positions would depress potential upside in Canadian bank stocks.
None of this is to suggest that domestic bank stocks are a bad investment. Foreign hedge fund managers may not know that, historically, betting against Canadian banks has been a terrible and unprofitable idea, but domestic investors are fully aware. But if domestic bank stock prices continue to tread water in the next few months, we might know where to look for the culprits.
Major Banks: Short Interest as % of Float
Current
Dec. 29, 2017
Dec. 30, 2016
Dec. 31, 2015
RBC
TD
Bank of N.S.
BMO
CIBC
National Bank
0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Value of $10,000 Invested: U.S. vs. Canadian Banks
$19,000
S&P/TSX Bank Index
17,000
KBW U.S. Bank Index
15,000
13,000
11,000
9,000
7,000
5,000
2015
2016
2017
2018
u.s. bank stocks set to rally on higher bond yields
KBW Bank Index/S&P 500
U.S. 10-Y Treasury yield (%)
5.0%
3.5%
3.0
4.5%
2.5
4.0%
2.0
3.5%
1.5
3.0%
1.0
2.5%
0.5
2.0%
0
2015
2016
2017
2018
THE GLOBE AND MAIL, SOURCE: scott barlow;
bloomberg
Major Banks: Short Interest as % of Float
Current
Dec. 29, 2017
Dec. 30, 2016
Dec. 31, 2015
Royal Bank of Canada
Toronto-Dominion
Bank of Nova Scotia
Bank of Montreal
CIBC
National Bank
0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Value of $10,000 Invested: U.S. vs. Canadian Banks
$19,000
S&P/TSX Bank Index
17,000
KBW U.S. Bank Index
15,000
13,000
11,000
9,000
7,000
5,000
2015
2016
2017
2018
u.s. bank stocks set to rally on higher bond yields
KBW Bank Index/S&P 500
U.S. 10-year Treasury yield (%)
5.0%
3.5%
3.0
4.5%
2.5
4.0%
2.0
3.5%
1.5
3.0%
1.0
2.5%
0.5
2.0%
0
2015
2016
2017
2018
THE GLOBE AND MAIL, SOURCE: scott barlow; bloomberg
Major Banks: Short Interest as % of Float
Current
Dec. 29, 2017
Dec. 30, 2016
Dec. 31, 2015
Royal Bank of Canada
Toronto-Dominion Bank
Bank of Nova Scotia
Bank of Montreal
CIBC
National Bank of Canada
0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Value of $10,000 Invested: U.S. vs. Canadian Banks
$19,000
S&P/TSX Bank Index
17,000
KBW U.S. Bank Index
15,000
13,000
11,000
9,000
7,000
5,000
2015
2016
2017
2018
u.s. bank stocks set to rally on higher bond yields
KBW Bank Index/S&P 500
U.S. 10-year Treasury yield (%)
5.0%
3.5%
3.0
4.5%
2.5
4.0%
2.0
3.5%
1.5
3.0%
1.0
2.5%
0.5
2.0%
0
2015
2016
2017
2018
JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE: scott barlow; bloomberg
Scott Barlow