Financials Outperformed in August, but Here’s Why That’s Likely to End Soon

The Financial Select Sector SPDR Fund (NYSE:XLF) led most major sector ETFs in August with a 3.6% monthly gain, but the financials could be in for a rude awakening soon due to a flattening yield curve.

The XLF had already posted decent gains in August prior to the Fed’s Jackson Hole announcement last Friday, but the allegedly hawkish (rates rising) tone of chair Janet Yellen’s speech really sparked investor interest. Many analysts and pundits now believe a rate hike will come this month, although the market-implied odds of a September hike are only around 33%.

August’s rally, however, occurred amid a flattening yield curve. That means the spread between short- and long-term interest rates compressed (“flattened”), all the way down to lowest spread since the end of 2007. Generally speaking, flat yield curves are indicators of an economic slowdown (or even a recession).

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If you remember, back in 2007, people brushed off the idea of an economic slowdown and piled into the financials. And we all know how that one ended.

That’s not to say that a market crash is coming soon. It’s just that the financials’ recent rally wasn’t based on anything of substance, and that many headwinds persist in the banking industry.

Financials will be further exposed in a couple of weeks when the S&P breaks real estate out of the sector into its own group. That move, which seems rooted in benefitting indexes and issuers rather than serving investors, will take high-flying real estate plays out of the XLF and leave the focus squarely on U.S. banks.

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The XLF fell $0.20 (-0.83%) to $24.35 per share in morning trading today. XLF has risen about 2% since the start of 2016, trailing the 7% gain of the S&P 500 in the same period by a wide margin.