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Bank ETFs Fail to Rally Despite a Hawkish Fed: Here's Why

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As widely expected, the Fed effected the second-rate hike of this year in its June meeting. The focal point of the meet was the Fed’s signal at two more hikes this year in contrast to the previous projection of three increases in total.

Federal funds rate projections were raised to 2.4% for 2018 from 2.1% in March, to 3.1% for 2019 from 2.9% while the projections remain the same for 2020. And the Fed chair Powell appeared confident about the wellbeing of the U.S. economy.

The meeting had the maximum impact on the two-year U.S. Treasury yield, which rose to the highest level since 2008 of 2.59% (up 5 bps from 2.54% the day earlier) on Jun 13. Such a steep rise was probably because of an unexpectedly hawkish Fed guidance. On the other hand, the yield on the 10-year U.S. Treasury was relatively stable, up to 2.98% on Jun 13 from 2.96% recorded the previous day.

Flattening Yield Curve

Thanks to the probability of faster-than-expected Fed rate hikes, the short end of the yield curve is rising faster than the long end, narrowing the spread between both the two yields. The spread between the 2-year and 10-year yields was 39 bps on Jun 13, down from 42 bps at the start of the month, indicating a flattening yield curve.

Since banks borrow money at short-term rates and lend capital at long-term rates, steepening of the yield curve bodes well for bank ETFs. But this is not the case right now. And if the yield curve flattens, net interest rate margins of banks decline. This clearly explains the underperformance of bank ETFs(read: ETF Strategies to Play the 7-Year High Benchmark Yield).

Investors should also note that though rising rate concerns have been rife this year, the yield curve has actually flattened so far. At the start of the year, the spread between the 2-year and 10-year yields was 54 bps, much higher than the present 39 bps.

Actually, the movement of short-term bonds is more dependent on Fed behavior than long-term bonds. While a hawkish Fed kept pushing short-term bond yields higher, geopolitical risks and trade war tensions occasionally boosted a flight to safety this year and kept the rise in long-term bond yields at check. 

Regional Bond ETFs in Focus

Thanks to the above-mentioned factors, most financial ETFs retreated on Jun 13. These include SPDR S&P Regional Banking ETF (KRE - Free Report) (down 0.4%), iShares US Regional Banks ETF (IAT - Free Report) (down 0.4%) and Invesco KBW Regional Banking ETF (KBWR - Free Report) (down 0.2%) and Financial Select Sector SPDRÂ ETF (XLF - Free Report) (down 0.4%).

Time to Look at Inverse Financial ETFs?

However, there are ways for investors to cash in on this situation. Investors can bet on inverse financial ETFs and profit out of it.

Direxion Daily Regional Banks Bear 3X ETF (WDRW - Free Report) – up 4.4% on Jun 13

Direxion Daily Financial Bear 3X ETF (FAZ - Free Report) – up 1.8%

ProShares UltraShort Financials (SKF - Free Report) – up 1.2%

ProShares Short Financials (SEF - Free Report) – up 0.5%

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 (see: all the Inverse Equity ETFs here).

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