In this post, we want to share some research that was provided to our US Subscribers, which attempts to explain why the difference in Interest Rates in Europe and the US is causing trouble in the markets.
Everything between the horizontal lines was written for US subscribers, so keep that in mind as you’re reading it. The conclusion/takeaway for India is way at the bottom in bold.
First, let’s start with the 10-2 Year Spreads in the US and Germany. As we can see, the US spread recently pushed towards its Q2 highs, while the German spread pushed towards new lows.
And this isn’t just a German story. We’re seeing similar weakness in Yield Curves across Europe. And what effect is that having? Well, European Banks are pressing to multi-month lows on an absolute basis.
And over the last week, Bonds have caught a bid globally causing the weakness we were seeing in Europe to spread to US Banks.
They’ve performed better than European Banks since the March lows and are still above long-term support. So while weakness in the near-term is likely to continue, we’re not making the bet that US Banks going to completely collapse (at least not until they break support near 23).
And that’s in part due to what we’re seeing in Community and Regional Banks on a relative basis. Because these smaller banks are primarily focused on lending, their performance should be more in-line with the US Yield Curve than the larger banks with more diversified businesses.
Continued outperformance here would suggest the market is still pricing in a steepening yield curve in the US over the long-term, despite the weakness in Europe and other countries. And notice the relative performance here compared to EUFN or XLF which hold the larger banking stocks?
The difference in European and US Yields also helps explain the underlying bid in the US Dollar. If market participants are not getting yield in Europe, they’re going to get it somewhere. So they exchange their Euros for US Dollars and then use those Dollars to buy higher-yielding US Treasuries.
So what’s the takeaway from all this? Yields in the US are unlikely to go higher if the rest of the world’s Yields are in the gutter.
The things getting hit the worst are areas with the most exposure to Financials. Just take a look at Emerging Markets relative to Developed Markets Ex-North America hitting 7-year highs. I’d posit this has a lot to do with the sector composition of these indexes.
Banks will remain a headwind for the broader market, that’s a given.
But more importantly, we think the message is that if you absolutely need to own Banks, own those in the US or in other countries where the Yield Curve is still steepening, not flattening. And own the Community/Regional Banks as opposed to the larger diversified plays that aren’t as positively correlated with the Yield Curve.
While this is not directly related to a trade we’re putting on in India, we thought this was an important context given the International weakness in Europe and other areas with heavy Financials exposure has been a headwind for Equities as an asset class.
And in case you were wondering, the Indian Yield Curve is steepening, which is why Financials in India have held up better than in other areas of the world like Europe or Canada.
As always, thanks for reading and please let us know if you have any questions!If you enjoyed this post and want to access all of our premium content, start a 30-day risk-free trial. Or sign up for our “Free Chart of the Week” to receive more free research like this.