Regional banks slipped into the bear market territory on Dec 4, thanks to flattening of the yield curve. Shares of SunTrust , Citizens Financial Group CFG, Fifth Third Bancorp (FITB - Free Report) and Regions Financial Corp. (RF - Free Report) lost more than 5% on the day as the yield on the benchmark 30-year Treasury bond dropped 11 basis points (bps) to 3.16% and the yield on the 10-year Treasury note fell 8 bps to 2.91%.
On the other hand, short-term treasury yields rose for one-month, two-month, three-month and six-month period. Yields for those terms increased 7 bps, 7 bps, 4 bps and 2 bps, respectively, on Dec 4 from the earlier day. This led to the flattening of the yield curve — a predominant this year (read: Bank ETFs Fail to Rally Despite a Hawkish Fed: Here's Why).
Investors should note that the U.S. Treasury yield curve inverted on Dec 3 for the first time since 2007and continued the trend. DoubleLine CEO Jeffrey Gundlach believes that the recent inversion of the U.S. Treasury yield curve hints at the weakening of the economy. As a result, SPDR S&P Regional Banking ETF (KRE - Free Report) was down 5.3% on Dec 4 and has lost more than 20% from its all-time high reached in June, ensuring a bear market.
Inside the Flattening and Inverse of Yield Curve
Concerns of an imminent slowdown in economic activity and falling inflation expectations amid Fed policy tightening led to the treasury yield curve pattern and hit bank shares. Actually, the movement of short-term bonds is more dependent on Fed behavior than long-term bonds. The Fed has enacted three rate hikes this year and is likely to pass the fourth this month.
A hawkish Fed kept pushing short-term bond yields higher this year. But geopolitical risks, slowdown in the Euro zone and Japan, still-alive U.S.-Sino trade war tensions and Brexit fears occasionally boosted a flight to safety this year and kept the rise in long-term bond yields in check.
Since banks borrow money at short-term rates and lend at long-term rates, flattening of the yield curve bodes ill for bank ETFs. If the yield curve flattens, net interest rate margins of banks decline. This clearly explains the underperformance of bank ETFs. Also, if the economy wanes, poorer activity and slower loan growth will likely be in the cards.
What About Big Banks?
Not only smaller banks, big banks have been under pressure as well. Shares of Citigroup (C - Free Report) and Morgan Stanley (MS - Free Report) dropped to lows not seen since June 2017. Both stocks lost about 4.5% and 5% on Dec 4. Meanwhile, JPMorgan Chase & Co. (JPM - Free Report) , Goldman Sachs Group Inc. (GS - Free Report) and Wells Fargo & Company (WFC - Free Report) lost 3.8% to 4.5%.
What Lies Ahead?
As of now, there is a 78.4% probability of a rate hike in the Fed’s December meeting. Probably, markets have been pricing the move and that is why we have noticed a sharp rally in short-term yields. But if the Fed comes up with a dovish outlook for 2019, things may change in the coming days. The CME FedWatch Tool already shows a reduction in hawkish expectations. While there was an 84.4% chance of an upcoming rate hike on Dec 3, the probability moved down to 78.4% on the next day.
Inverse Financial ETFs to Play
There are ways for investors to cash in on the bearish situation. Investors can bet on inverse financial ETFs and profit out of it (read: What Caused Huge Outflows in Regional Bank ETFs in November).
Direxion Daily Regional Banks Bear 3X ETF WDRW — up 16.5% on Dec 4
Direxion Daily Financial Bear 3X ETF (FAZ - Free Report) — up 11.2%
ProShares UltraShort Financials (SKF - Free Report) — up 7.71%
ProShares Short Financials (SEF - Free Report) — up 3.8%
As a caveat, 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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