The Financial Services Sector of the stock market has been the 2nd best performing sector so far this year. A sector of the market consists of similar industries and those which have other things in common such as, in this case, interest rate sensitivity (there are a total of 11 sectors that make up the stock market). Yields on bonds, US Treasury bonds, directly impact banks and financial services companies as well as the overall market. The yield of the 10-year US Treasury note is closely watched as it has a direct impact on the overall stock market as well as the Financial sector. This is because when yields rise it is thought that banks and other financial services companies stand to increase their revenues and their profits as a result. Yields help determine the rate a bank can charge for lending money and as they rise the banks’ revenues and profits rise faster than their costs. Note yields impact the rates of interest that banks can charge but are not the same as stated interest rates you typically see with regards to rates like the Federal Reserve’s Federal Funds rates.
Rates on the 10-year Treasury note have been climbing for several months now. At this writing, the yield was at 1.74%. That is up from a low of just .57% in April of last year, nearly tripling. At the time when the rate was that low, prospects for banks were quite grim especially since there were fears that banks and other lenders might be facing steep losses because of the substantial economic downturn brought on by the pandemic. Banks also had to move to set aside additional reserves for those potential losses. That is money the banks could not lend out. While banks could invest those reserves in things like Treasuries, (which are quite conservative) they stood to make somewhat less on their reserves.
In mid-March, it was reported that banks had somewhat exceeded the amount they needed to have in additional loss reserves as the fears of loan losses continued to decrease as the economic picture continued to improve. That put many lending institutions in a position to free up those reserves that were into higher yielding loans and hence drive greater revenues and profits to the lending institutions. Shortly following that however, the Federal Reserve made changes to some pandemic era rules put in place last year that allowed banks to exclude (from something known as their supplementary leverage ratios), the Treasury securities they held in their Federal Reserve deposits. With that no longer being the case, banks were suddenly faced with lower revenues because of those changes since they would have to increase their reserves with non-US Treasuries. This is an example of the risk of investing and the impact of unexpected events, in this case the change of a previously favorable regulation.
Nonetheless, if yields continue to rise, that would be increased potential for revenues for banks and lending institutions. So where might an investor look if she or he wanted to add financials to their portfolio?
There are over 5,000 banks in the United States. They range in size from the big, so called money center banks, to the much smaller community banks. In between are regional banks. There is a plethora of research available for investors to review when considering the sector. They can look at individual stocks of financials, mutual funds, and exchange traded funds. Additionally, many of these may offer attractive dividend yields to their investors as well.
Also, some financial services companies offer online accounts, credit cards and loans. Brokerage firms too are part of this sector. Many brokerage firms have banking subsidiaries where uninvested cash of their customers is held. Those subsidiaries stand to make greater earnings when yields increase. There are also a multitude of “fintech” companies which stand to improve their earnings when yields increase.
What might be driving the increase in yields? The most simple explanation is expectation of economic growth or economic rebound. That would be a signal that demand is growing, and that inflation is increasing. Large institutional investors like pension plans, endowments, and funds tend to sell lower yielding Treasuries as a result. More selling than buying drives the price of bonds and treasuries down but conversely drives the yield up.
The Federal Reserve has two main objectives: One is full employment and the other is keeping inflation in check. The Fed has most recently indicated that it does not see inflation as a particular threat and is prepared to keep rates close to zero until 2023. Note those are rates, not the yields. The daily trading of US Treasury bonds determines the yields. Some inflation is considered healthy for economic growth. That is typically from 2-3%. Investors however appear to be more concerned with inflation as supply interruptions and price increases of various commodities have moved producer and consumer prices up. Left unchecked, inflation eventually erodes purchasing power which is harmful for consumers and the economy.
If you want to learn more or want to make some adjustments to your investing plans, be sure to use your resources. Ask your advisor or brokerage firm for information, research, advice, or input. In some situations, investors prefer to delegate that decision making to an advisor or money manager. In any case, continue to understand and know what you own and why you own it.
Maurice Stouse is a Financial Advisor and the branch manager of The First Wealth Management and Raymond James and he resides in Grayton Beach. He has been in financial services for over 34 years. His main office is located at First Florida Bank, a division of the First, A National Banking Association, 2000 98 Palms Blvd, Destin, FL 32541. Branch offices in Niceville, Mary Esther, Miramar Beach, Freeport and Panama City, Pensacola, Tallahassee, and Moultrie, GA. Phone 850.654.8124. Raymond James advisors do not offer tax advice. Please see your tax professionals. Email: Maurice.firstname.lastname@example.org.Securities offered through Raymond James Financial Services, Inc. Member FINRA/SIPC, and are not insured by bank insurance, the FDIC, or any other government agency, are not deposits or obligations of the bank, are not guaranteed by the bank, and are subject to risks, including the possible loss of principal. Investment Advisory Services are offered through Raymond James Financial Services Advisors, Inc. The First Wealth Management First Florida Bank, and The First, A National Banking Association are not registered broker/dealers and are independent of Raymond James Financial Services. Views expressed are the current opinion of the author, not necessarily those of RJFS or Raymond James, and are subject to change without notice. Information provided is general in nature and is not a complete statement of all information necessary for making an investment decision and is not a recommendation or a solicitation to buy or sell any security. Past performance is not indicative of future results.
Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation. Investors should consult their investment professional prior to making an investment decision.
Sector investments are companies engaged in business related to a specific sector. They are subject to fierce competition and their products and services may be subject to rapid obsolescence. There are additional risks associated with investing in an individual sector, including limited diversification.