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Which way U.S. banks stocks? Look to the yield curve

U.S. financial stocks drastically outperformed the S&P 500 in 2012 and the world's most famous investor believes the rally has just begun. Warren Buffett, the man who kicked off the market recovery in March of 2009 with positive comments about Wells Fargo & Co., is again optimistic about the future of bank stocks. The yield curve will tell us if he's right.

In an interview with Bloomberg, Mr. Buffett said the U.S. financial system is no longer a risk to the economy because the "excesses on the [balance sheet] have been largely cleared out" and capital ratios are healthy. As the largest shareholder in Wells Fargo and a multi-billion-dollar investor in Goldman Sachs and Bank of America, Mr. Buffett has already backed his convictions with his considerable wallet.

The five largest U.S. investment banks – JPMorgan, Bank of America, Citigroup, Goldman Sachs and Morgan Stanley – provided investors with a 32-per-cent return last year, led by Bank of America's stunning 103-per-cent appreciation. Perhaps more importantly, bank stocks reconnected with underlying interest rate fundamentals, which may make the future course of the sector's stock prices more predictable.

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The profits at the banks are largely determined by their ability to borrow funds at low short-term interest rates and lend to clients at higher, longer-term rates. For this reason, the steepening of the U.S. yield curve in 2012 – indicating a growing gap between short-term and long-term rates – was a major factor driving banks stocks higher.

The chart to the left shows the stock performance of the five major U.S. investment banks versus the steepness of the yield curve – here measured by the difference between two-year and 10-year Treasury yields. Before the financial crisis, a market-cap-weighted benchmark of the investment bank stocks closely followed changes in curve steepness. As the crisis intensified in late 2008, the U.S. Federal Reserve intervened in interest rate markets while faith in bank balance sheets declined and the relationship between bank stocks and yields deteriorated.

The strong rally in bank stocks began when curve steepness bottomed in May, suggesting that the historically close relationship between investment bank profits and the yield curve has returned. Bank stocks continued to rise along with curve steepness through the rest of 2012. More steepening will provide evidence that Mr. Buffett's faith in U.S. banking stocks is justified.

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About the Author
Market Strategist

Scott Barlow is The Globe's in-house market strategist. He is a 20-year veteran of Canadian investment banks, including Merrill Lynch Canada, CIBC Wood Gundy and Macquarie Private Wealth (MPW). He was a highly ranked mutual fund analyst for 10 years and then, most recently, the head of a financial adviser support team at MPW. More

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