Rates on the 10-year Treasury have plunged 4.5% since late October, while interest rates on shorter-dated bonds have held steady or increased. This has caused the yield curve to flatten like a pancake, typically a precursor to a recession.
Economic growth in the United States reached 3% last quarter and strong global growth doesn't seem to point to an end of the eight-year recovery, but there is one sector that has been punished on the drop in rates.
Yields on the 10-year have fallen to within 0.69% of the yield on the two-year note, the narrowest since 2007. That narrowing of rates between short- and long-term bonds is wreaking havoc on a sector that was supposed to be one of the biggest beneficiaries to economic growth and the trend to deregulation this year.
There are several catalysts pointing to a potential reversal in the trend to lower long-term rates, meaning that this sector could bounce coming into the new year.
Shares of banks and other financials have been hammered on the drop in long-term rates, with the Financial Select Sector SPDR (NYSE: XLF) tumbling 2.7% over the last three weeks against a 0.7% gain in the broader market. That's because these firms make money by paying rates on short-term loans and deposits while lending money out at higher, long-term rates.
Rates on the shorter end of the curve are holding up as the Federal Reserve pulls back on monetary stimulus and carries through with its plan to raise rates. The Fed has increased rates three times in the last year and is expected to raise again in December.
The drop in long-term rates against relative strength on the short-term side means a narrower interest margin for banks and weaker profits.
Analysis by Scott Dorf of Bloomberg suggests that much of the reason for lower long-term rates lately is due to hedge funds and other leveraged players in the futures market, buying up bonds and forcing rates lower. There's also evidence that pension funds are buying into the long-term bond market.
While shorter-dated bonds will likely see rates move higher gradually, there's good reason to believe that rates on long-term bonds could jump soon.
Any tax reform or other fiscal stimulus will mean a surge in government deficits and the need for more borrowing, meaning higher rates must be offered to attract investors. The stimulus could drive economic growth and stoke fears of inflation, both factors that would further push long-term rates higher.
There's also a wave of corporate debt maturities coming in 2018. More than $95 billion in high-yield debt is maturing next year and $1 trillion over the next five years, compared to approximately $47 billion in high-yield maturities this year. Total global corporate debt maturities of $5.8 trillion over the three years to 2020 could mean much higher rates as corporates compete to refinance debt.
As interest rates on long-term bonds increase, hedge funds and other trend followers in the futures market could be forced to sell out of positions. That would send bond prices lower and cause rates to move even higher.
Three Best-Of-Breed Banks Benefitting From Higher Rates
Higher long-term rates and a sloping yield curve could breathe new life into financials and any headlines on financial deregulation could cause shares to surge. I'm looking at three banks with strong business models and attractively-priced shares.
Citigroup (NYSE: C) has a larger global presence compared to other retail-focused banks, which helps it tap growth in developing markets. The Bank of England recently raised rates for the first time in two years and the ECB is talking about the end of its bond-buying program as well. This should mean that global rates rise along with those in the United States and support Citigroup's international operations.
Citigroup has underperformed on its return on assets (0.77) over the last several years due to non-interest expenses related to litigation costs. These costs should trend lower as the bank puts the financial crisis further behind it, returning to greater profitability. The bank is aggressively returning capital to shareholders, reducing the share count by 7% over the last year through a buyback. Shares trade at a price-to-book of just 0.9 times and pay a 1.8% dividend.
Wells Fargo (NYSE: WFC) is higher by just 4.8% over the last year on the account scandal and a rare hit to an otherwise strong name for customer service. The bank is the largest deposit gatherer in the country and a leader in the mortgage market, making it especially susceptible to the yield curve.
Return on assets has slumped to 1.0 times this year from 1.4 in 2013, leaving room for stronger profitability on management's turnaround plan. Non-performing assets have shrunk for four consecutive quarters and the bank has been able to grow deposits consistently. Shares trade at a price-to-book of 1.5 times and pay a 2.9% dividend.
Capital One Financial (NYSE: COF) is relatively more diversified across lending than some of the other retail banks, with 42% of its loan portfolio in credit cards followed by consumer loans (31%) and commercial banking (28%). The company's deposit business is slightly more leveraged to CDs and money market funds than other retail banks, but cost of deposits is still low at 0.61% for 2016.
Credit cards are not as sensitive to changes in interest rates, but the bank has been growing its loan portfolio and should still benefit from changes in the yield curve. Consumers have been slow returning to credit after the financial crisis but seem to be coming back. Capital One reported an increase in card loans of 10% in the third quarter along with a 5% year-over-year increase in consumer loans and 2% growth in commercial banking. Shares trade at a price-to-book of just 0.9 times and pay a 1.8% dividend.
Risks To Consider: An economic recession is unlikely in the short-term but would hit financials on lower loan demand and falling interest rates.
Action To Take: Get ahead of higher long-term rates with a position in banks and other financials that will benefit from higher lending rates.
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