Last week, we noted that the US utility sector's improving performance suggests that the Federal Reserve is less likely to raise interest rates aggressively over the rest of the year. We said,
if we see a lukewarm NFP report on Friday, it would raise the chances of another "dovish hike," where the FOMC raises interest rates but strives to downplay expectations for future interest rate hikes this year. That scenario could result in continued strength in higher-yield utility and REIT stocks, as well as underperformance in regional banks and the US dollar.
As our readers should know by now, Friday's jobs report was indeed tepid, showing that only 138k new jobs were created in May, well below expectations of a 180k gain. Today we look at another intermarket relationship, regional bank-stock performance, to see if it confirms the "lower-for-longer" case for US interest rates.
While most mega-banks make the majority of their profits through investment banking and trading activities, regional banks tend to be more straightforward. Their "bread-and-butter" business is borrowing and lending money, and their profits tend to fluctuate with the "net interest margin" or the difference between short-term interest rates used for borrowing money (i.e. through savings and checking accounts) and longer-term interest rates used for lending money (i.e. on business, car and home loans).
The chart below shows the recent performance of regional banking stocks (NYSE:KRE) and the 10-year and 2-year yield spread, a proxy for the "net interest margin":
Source: Stockcharts.com
As you can see, the 10-year—2-year yield spread (green) has more than reversed all of its gains since the US election, while regional banks have held up better. This divergence is unlikely to hold for long. In our view, either the yield curve will start steepening again, or regional banking stocks will drop sharply to "catch down" with the recent drop in interest rates.
The level to watch on KRE is crystal clear: the 51.00 floor has provided support for regional banks on three separate occasions in the last three months and the rising 200-day moving average comes in almost exactly at that same level. If the 51.00 level gives way, the selling pressure in regional banks is likely to accelerate, with KRE potentially dropping to the mid or lower 40s in a short period of time.
Of course, we're always willing to consider the alternative scenario, even if it is less likely in our view. If the Fed comes off as more hawkish in its meeting in a week's time, the yield curve could steepen once again and KRE could break out above its descending triangle pattern. In that case, the index could recover back to the upper 50s by the end of the summer.
For readers who prefer focusing on individual stocks, the largest holdings in the regional bank ETF include CIT Group (NYSE:CIT), Keycorp (NYSE:KEY), Citizens Financial Group (NYSE:CFG), SunTrust Banks (NYSE:STI) Cullen/Frost Bankers (NYSE:CFR), First Republic Bank (NYSE:FRC), PNC Financial Services Group (NYSE:PNC) and M&T Bank Corp. (NYSE:MTB).