The banking sector enjoyed a nice run higher as investors saw the reality of rising interest rates getting closer. Banks make money by borrowing it at lower short-term interest rates and lending it at longer-term interest rates. So, the yield curve -- the difference between short- and long-term rates -- is critical.
If the Federal Reserve raises short-term rates, with all else being equal, the yield curve will flatten, making it harder for banks to make money. All things are never equal, though, and the chain of events in the capital markets is thought to push long-term rates higher, as well. Pundits think long-term rates will rise more than short rates, and that will make the yield curve steeper.
However, that does not seem to be happening now. The yield curve remains as flat as it has been since early July, which represented a nine-year low and a level last seen as the financial crisis was still unfolding.
While the yield curve spent the first half of September steepening and broke a one-year trendline to the upside, something happened mid-month to abruptly change that. Out of the blue, markets got nervous ahead of central bank meetings in Japan and the United States.
A look at the benchmark KBW Nasdaq Bank Index (BKX) gives us a feel for the sector's condition.
As we can see in the chart, the index has enjoyed a solid rally off the February lows, although it was seriously interrupted in the days leading up to the Brexit vote in late June. However, just as quickly as the sector fell, it rebound. By August, BKX had set an eight-month high.
Unfortunately, the technicals had deteriorated by that time. Resistance from the start of the steep December decline combined with waning momentum to stop the rally dead in its tracks.
Big banks such as Bank of America (NYSE: BAC) display similar patterns on the charts. Smaller banks' charts have been a bit more mixed, but one of the stronger ones up to this point -- Texas-based Cullen/Frost Bankers (NYSE: CFR) -- seems ready to succumb to the bears. And given its big rally this year, there is a lot of room for shares to fall.
Currently, CFR sits on the rising trendline drawn from its January low. From there to its high water mark in August, the stock gained nearly 75% compared to roughly 17% for the S&P 500.
This trendline is the key for our trade. In technical analysis, we must assume that trends are in effect until there is good evidence that they are not. In other words, patience is a virtue. We need a move below the trendline to confirm September's weakness was more than just a pullback.
Supporting the bearish case are divergences in such indicators as cumulative volume and Moving Average Convergence/Divergence (MACD). Even more important is the bearish reversal on Sept. 6, three days before the S&P 500 broke down from its tight two-month trading range. The S&P 500's breakdown was due to hawkish comments from the Federal Reserve suggesting short-term interest rates would soon begin to move higher.
Cullen/Frost also suffered a reversal on the weekly charts -- an "outside-week reversal" -- as the week opened at a new high but closed below the prior week's low.
Without knowing the news, this told us that something happened to change investors' minds. It could have been perceptions about what the Fed might do, or it could have been a case of simple profit-taking in a stock that had a good run but faced an overhead ceiling.
Currently, the stock trades just below its 50-day moving average. A break of the trendline below will also spark a "bowtie" crossover in the 10-day simple, 20-day exponential and 30-day exponential moving averages. When the three averages cross together, it forms the shape of a bowtie and, according to trader Dave Landry who popularized the pattern, the stock becomes tradeable to the downside.
The big reason I think we will see weakness ahead comes from the performance of the sector, especially Deutsche Bank (NYSE: DB). The entire sector remains locked in a bear market while DB just hit multiyear lows on concerns the bank may need a bailout.
Any further weakness in the sector should trigger a trendline breakdown in CFR, as well as a bowtie crossover, and confirm that the path of least resistance is to the downside. But as I mentioned above, we must wait for that breakdown to be confirmed with a drop below $67.85 before going short.
We'll place our target at the 50% retracement of the January-to-August rally at $58.25. A successful short would result in a 14% profit. That is certainly nothing to scoff at, but if you're ready to take your trading to the next level, there is a "backdoor" method that could return 5-10 times as much.
Recommended Trade Setup:
-- Sell CFR short below $67.85
-- Set stop-loss at $71.50
-- Set initial price target at $58.25 for a potential 14% gain in six weeks
-- Unlock the backdoor method here
This article originally appeared on ProfitableTrading.com: This Bank Is On The Verge Of A Major Sell Signal