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Yield Curve Inverted: Short Financials With ETFs

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Financial stocks have been going through a rough patch with Financial Select Sector SPDR ETF (XLF - Free Report) and SPDR S&P Bank ETF (KBE - Free Report) losing about 4% and 3%, respectively, in the past month. Both ETFs lost 3% each on Jun 13 as the yield curve inverted. U.S. two-year Treasury yields rose above 10-year treasury yields at one point on Jun 13, per Reuters. The curve had inverted in April too for the first time since 2019 before normalising.

At the close, the 10-year U.S. treasury yield was 3.43% versus 3.40% on the two-year treasury notes and 3.56% yield offered by the three-year treasury bonds. The Fed is likely to hike rates this week. Fears the Fed could go for an even larger rate hike than anticipated this week to contain scorching inflation sent two-year yields to their highest levels since 2007.

Many are expecting a 75/100 bps rate hike. Likewise, Barclays analysts expected a 75 bps move from the Fed on Wednesday instead of the 50 bps which has been priced in currently, as quoted on Reuters. Money markets are now pricing a cumulative 175 bps in hikes by September and see a 20% chance of a 75 bps move this week. If enacted, it would mark the largest single-meeting hike since 1994. Deutsche Bank expects rates peaking at 4.125% in mid-2023, the Reuters article indicated.

Meanwhile, recessionary fear sparked a safe-haven rally and did not let the benchmark 10-year U.S. Treasury yield top the three-year note. Global growth apprehensions emanating from a likely slowdown in Euro zone (as the ECB is also likely to hike rates in July) and rising COVID cases in China as and the United Kingdom also marred the risk-on sentiments.

As a result, the yield curve flattened. 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 on Jun 13.

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 was up 3.8% on Jun 13.

ProShares UltraShort Financials ETF (SKF - Free Report)

This fund seeks two times (2X) leveraged inverse exposure to the Dow Jones U.S. Financials Index. The fund advanced about 7.3% on Jun 13.

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.