Friday, October 15, 2010

Flattening Yield Curve: Good For Stocks But Bad For Banks

As the concerns about the economy have lessen, the Bank of Canada has moved to a more neutral monetary policy resulting in a gradual rise in short term interest rates. At the same time, long term rates have dropped reflecting  a re-emergence of deflationary fears in the U.S. This has caused a flattening in the yield curve as the spread or the difference between short and long term rates has narrowed.

Government of Canada Interest Rates

91 Day Tbill
10 Year Bond
Difference
April 28,2010
0.39%
3.66%
3.27%
October 13,2010
0.90%
2.73%
1.83%

The change has been significant. The current difference between long and short rates is 1.83% compared to 3.27% less than 6 months earlier. This phenomena has been happening the U.S. as well.

In a recent article Is the Flattening Yield Curve Good For Stocks?,  Liz Ann Sonders, Chief Investment Strategist for Charles Schwab & Co., Inc., discussed the implication for the stock market when the yield curve flattens. Her conclusion was: “Historically, a narrowing of the yield curve has been tied to stocks performing reasonably well.” In the 10 periods they studied when there has been a sharp decline in the yield  curve, the S&P was up on average 5.21% 3 months later,  and 17.97% 12 months later.

Although a flat yield curve might be good for stocks, it is generally considered  to be negative for bank stocks -  certainly compared to the rest of the market. Banks will typically borrow money at the short end and lend out money at the long end of the yield curve. The profit margin will shrink as the spread between long and short term rates narrows.

In the chart below, the S&P/TSX Composite is higher than it was  6 months ago yet the Financial sector is still below. The Financial sector has underperformed the overall market by 10% in the last 6 months. This under performance is similar in the U.S. and EAFE countries.
iShares S&P/TSX Composite (XIC) versus S&P/TSX Financial Sector Index (TTFS)
Bottom Line
As of October 14, 2010, the Financial Sector is the largest Industrial sector in the S&P/TSX Composite with a 29.1% weight. Most Canadian investors will have significant portion of their Canadian equity portfolio in Financials. It is important to  check  the sector weight in your portfolio and if it represents  more than 30%, then reducing the exposure could mean better performance and lower risk for your portfolio over the next 6 to 12 months.


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