From the Desk of Ian Culley @IanCulley
Fed Chair Jerome Powell has spoken…
And not much has changed. Rates churn sideways as bonds carve out tradeable lows.
The market is simply playing a new verse of the same old song.
But the tempo picks up as another antagonist enters the scene – regional banks!
Banks are the market’s weakest link, especially the smaller regional banks. They simply can’t stop falling.
To be clear: This isn’t about possible contagion risks or the next leg lower in the S&P 500. I’m more interested in the implications for interest rates.
The banking sector has captured every investor’s full attention. And regional banks have hinted at underlying problems with the rising rate environment for more than a year.
Check out the dual-pane chart of the Regional Bank ETF $KRE versus the REITs ETF $IYR ratio and the US 10-year yield $TNX:
Despite the KRE/IYR ratio peaking in March 2021, the 10-year yield continued to rise into the fall of last year. Therefore, I would expect regional banks to outperform real estate investment trusts as rates rise.
REITs tend to do well during periods of risk aversion while rising rates often speak to a risk-on environment. Plus, rising yields directly benefit many banks’ business models.
KRE’s inability to break above its prior cycle’s high relative to IYR was a poignant heads-up as many risk assets began to peak in spring 2021. Fast-forward to today, and fresh multi-year lows for this crucial intermarket ratio undoubtedly point rates lower.
But it’s not just KRE…
The broader bank sector ETF $KBE (which includes JPMorgan Chase & Co. $JPM and First Republic Bank $FRC) hints at lower rates and a potential steepening yield curve.
Notice KBE and the 2s-10s spread (inverted) follow the same path over longer time frames. The big difference: KBE peaked in January 2022, while the 2s-10s spread reached new multi-decade lows this past March (the lowest level since the early 1980s).
Will buyers bid up these bank stocks while the yield curve remains negative? Or, will we witness a steepening of the curve as banks search for a significant low?
My money is on the latter – and I imagine most investors would agree.
But it doesn’t matter. Powell’s goal from the onset of the hiking cycle was to squash inflation and destroy demand.
A little over a year later, the banking sector is sending a clear message: It’s working!
Now, we simply wait to read clues from the FOMC and the bond market.
Countdown to FOMC
The market is pricing in a pause in the hiking cycle following yesterday’s 25-basis-point increase.
Here are the target rate probabilities based on fed funds futures:
Click the table to enlarge the view.
Thanks for reading. As always, be sure to download this week’s Bond Report!