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Fearing an Inverted Yield Curve? Short Financials With ETFs

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Financial stocks have been going through a rough patch with Financial Select Sector SPDR ETF XLF and SPDR S&P Bank ETF (KBE - Free Report) losing about 3% and 4.1%, respectively, in the past week.The outcome of the latest Fed meeting, which reinforced the need for faster Fed rate hikes to counter accelerating inflation, caused an inverted yield curve last week.

The latest Fed meeting held on Mar 16 came across as hawkish. The Federal Reserve raised interest rates by a quarter of a percentage point and projected that its policy rate would be in the range of 1.75% and 2% by the year's end in a newly aggressive stance to fight the red-hot inflation. Hence, new Federal Reserve projections indicate six more rate hikes this year, per CNBC.

The Federal Funds rates are now projected in the range of 1.6% to 2.4% for 2022 (from 0.6% to 0.9% projected in December). For 2023, the same is projected in the range of 2.4% to 3.1% (from 1.4% to 1.9% range) and for 2024, the same is projected in the range of 2.4% to 3.4% (from 1.9% to 2.9% range).

The Fed also hiked its inflation forecast for the year. The central bank now expects the median inflation rate to jump to 4.3% this year, higher than its previous forecast of 2.6%. PCE inflation expectation has gone up to 2.7% for 2023 from 2.3% projected in December. The Fed downgraded its forecast for 2022 median real GDP growth from 4% in December to 2.8% for 2022. However, it kept the growth rate expectations same at 2.2% for 2023 and 2% for 2024.

The 2-year and 10-year Treasury yields inverted for the first time since 2019 on Mar 31, sending threatening cues that a recession could be in the cards. The 2-year to 10-year spread was last in negative territory in 2019, when global growth apprehensions emanating from slowdown in Euro zone and China as well as Brexit issues had marred the risk-on sentiments.

Inverted Yield Curve

All these sparked a safe-haven rally and led the benchmark 10-year U.S. Treasury yield to drop to 2.38% on Apr 1 from 2.48% from Mar 25. The spread between benchmark U.S. treasury yield and the three-year treasury yield were negative 20 bps on Apr 1.

This kind of a flattening yield curve is negative for financial stocks. Since banks borrow money at short-term rates and lend capital at long-term rates, a lower long-term rate does not bode well. If the yield curve flattens, net interest rate margins of banks decline. This clearly explains the underperformance of banks or overall financial ETFs.

Inverse Financial ETFs

Given the prevailing bearish outlook, the appeal for financial ETFs, especially banks, is dull for the near term. As a result, investors who are bearish on the sector now may want to consider a near-term short. There are several inverse financial ETFs to play this kind of a flattening yield curve scenario. Below we highlight a few of them.

ProShares Short Financials ETF (SEF - Free Report)

This fund provides unleveraged inverse (or opposite) exposure to the daily performance of the Dow Jones U.S. Financials Index. The ETF makes a profit when the financial stocks decline and is suitable for hedging purposes against the fall of these stocks. The fund is up 3.9% past week.

ProShares UltraShort Financials ETF (SKF)

This fund seeks two times (2X) leveraged inverse exposure to the Dow Jones U.S. Financials Index. The fund has advanced about 1.8% past week.

Bottom Line

As a caveat, investors should note that such products are suitable only for short-term traders as these are rebalanced on a daily basis. Still, for ETF investors who are bearish on the financial sector for the near term, either of the above products could make an interesting choice.

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