A Yield Curve Issue Faces Bank ETFs

Since the start of this year, bank-heavy exchange traded funds, such as the Financial Select Sector SPDR Fund XLF and the SPDR S&P Regional Banking (ETF) KRE, have been hoping and waiting for the Federal Reserve to raise interest rates.

Nearly nine months into the year, with higher rates having yet to come to town and just over three months left in the year, it looks like the year will see one more rate hike at the most. Taking ongoing Fed disappointment into account, perhaps it is an accomplishment that XLF is up 0.1 percent year-to-date while KRE is down by the same amount.

Now, bank stocks and ETFs face another concern: a flattening yield curve.

When Curves Go Flat

“A flattening yield curve could continue to pressure US bank margins following the latest Federal Reserve open market committee (FOMC) meeting where the medium-term projection for the Fed funds target rate was lowered again,” said Fitch Ratings in a recent note.

Related Link: 3 Stocks That Could Benefit As Fed Considers Easier Stress Tests For Regional Banks

The Fed is almost universally viewed as one of the most determinants of performance for ETFs such as XLF and KRE, but the central bank does not appear likely to oblige as bonds markets are pricing in diminishing odds of even one rate hike before the end of this year. That deals a blow to a sector and its ETFs that came into 2016 with hopes of up to four rate hikes.

Regional bank funds like KRE are seen as prime beneficiaries of higher interest rates. Simply put, net interest margins at regional banks have been suppressed by the Fed's zero interest rate policy and reversing that policy is seen as an important catalyst in boosting profits for the banks in ETFs such as KRE.

Interest Rates And Regional Banks

Higher interest rates are seen as boons for regional banks' net interest margins, a key measure of profitability for these banks. KRE's positive correlation to rising Treasury yields is nearly double that of XLF's. Simply put, declining expectations for higher interest rates has an adverse impact on net interest margins, which is obviously a negative for bank equities and ETFs.

“The uncertainty over the rate trajectory and terminal rate, coupled with the unprecedented length of this low rate period, remain key challenges and sources of uncertainty for the US banking sector. That said, Fitch believes that rate risks alone are unlikely to pose major risks to bank credit profiles or ratings,” added Fitch.

Full ratings data available on Benzinga Pro.

Disclosure: Todd Shriber own shares of XLF.