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Why Financial ETFs Are Down Despite Decent Bank Earnings

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The financial sector, which accounts for around one-fifth of the S&P 500 index, is now busy with Q3 earnings releases. The going is great so far, with four big banks crushing estimates on both lines and two posting mixed results. The backdrop should favor banks along with the course of oil, the stance taken by the Fed and the proposed policies of President Donald Trump.

Earnings in Detail

About 41.5% of the total market cap has already reported earnings, of which 86.7% registered earnings beat and 20% expansion in the bottom line. About 60% companies surpassed the revenue estimates and reported 5.3% top-line growth, per Earnings Trends issued on Oct 17, 2018.

Goldman (GS - Free Report) , Morgan Stanley (MS - Free Report) , J.P. Morgan (JPM - Free Report) and Bank of America Corporation (BAC - Free Report) came up with a beat on both lines. Revenues of Wells Fargo (WFC - Free Report) and Citigroup (C - Free Report) matched the Zacks Consensus Estimate, while earnings of the former missed expectations and the latter managed a beat.

Overall, there are expectations that the financial sector would log 35.4% increase in earnings in the third quarter, higher than 21.5% growth seen in the second quarter.

Market Impact

Investors, who still have their hopes pinned on a decent earnings season, and faster Fed policy tightening, must be keen on knowing how financial ETFs like iShares U.S. Financial Services ETF (IYG - Free Report) , iShares US Financials ETF (IYF - Free Report) , Invesco KBW Bank ETF (KBWB - Free Report) , Financial Select Sector SPDR (XLF - Free Report) and Vanguard Financials ETF (VFH - Free Report) responded to earnings releases. These funds have considerable exposure to the aforementioned stocks (see all Financial ETFs here).

Goldman and Morgan Stanley are not that prominent in the afore-mentioned ETFs, rather they are heavy on iShares U.S. Broker-Dealers & Securities Exchanges ETF (IAI - Free Report) .

What Caused the Slump in Financial ETFs?

As we can see from the above-mentioned chart that all those ETFs have lost severely in the past 10 days – the period dotted with big bank releases. One of the reasons behind this could be broad-based market blues that we witnessed during this phase. And the second reason is possibly flattening of the yield curve.

Thanks to the probability of faster-than-expected Fed rate hikes, the short end of the yield curve is slightly 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 28 bps on Oct 22, down from 34 bps on Oct 10, 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. And if the yield curve flattens, net interest rate margins of banks decline. This clearly explains the underperformance of bank ETFs.

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.

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