After lackluster performance last year, regional banks have been leading the financial sector higher for most of this year. This space has been a solid player as a strong dollar and global growth concerns compelled investors to look for U.S. exposure.
Rates Hike in Cards
In its latest FOMC meeting, the Fed clearly stated that it is on track to raise interest rates sometime later this year given the substantial improvement in the economy after a winter swoon but the timing is still uncertain. Further, the pace of increase would be slower and gradual than market expectation, citing concerns over sill low inflation and job market recovery.
As such, the first rate hike since 2006 will only take place when job market continues to show strong progress and inflation rises to the 2% target over the medium term. If this happens, the Fed officials are expecting at least one or perhaps two rate increases this year. Though short-term interest rates will rise slowly, a strengthening economy and accelerating job market will drive long-term interest rates higher, thereby widening the spread between the long and short-term rates.
To make it clear, let’s look at the yield of the short-term and long-term bonds. The yield on 10-year Treasury bonds rose to 2.320% from 2.128% at the end of May while the yield on 3-month Treasury bonds was relatively flat at 0.010% since the start of June. The yield spread is currently 2.31% at the time of writing as against 2.118% at the end of May, reflecting higher spreads and resultant higher profits for the banks.
In fact, the yield curve between 5-year notes and 30-year bonds steepened to 150 bps on June 18, representing the steepest yield curve in a month following the upbeat economic data on inflation that strengthened the Fed rate hike stance.
Most of the regional banks now have much stronger balance sheets and their quality of earnings is improving on a step-up in the economy. Added to the strength is solid loan growth, higher trading income, rising credit quality and litigation settlements. As the banks’ loan portfolio gains health, they will need less loan loss reserves in the future pointing to gainful trading for banking stocks.
Given encouraging fundamentals, investors are seeking to bank on this regional banking space. For those, any of the following ETFs could be solid picks to ride out the steepening yield curve:
This is one of largest and the most popular ETFs in the banking space with AUM of nearly $2.5 billion and average daily volume of more than 4 million shares. The product follows the S&P Regional Banks Select Industry Index, charging investors 35 basis points a year in fees. Holding 91 securities in its basket, the fund is widely spread out across each security with an equal-weigh approach of around 1%. Small cap dominates the fund’s return at 76%, followed by mid caps (18%) and large caps (6%). The fund has gained about 10% in the year-to-date timeframe.