What does the chart show?

The chart shows the US 10-year government bond yield (blue line) and the share price performance of the S&P Banks Index relative to the S&P 500 (yellow line). An upward sloping yellow line indicates the S&P Banks Index is outperforming the broader S&P 500 Index, whereas a downward sloping line means it is underperforming. Through time there has been a fairly close relationship between the two – higher yields have been positive for banks whilst lower yields are often associated with underperformance. Since the bottom of the pandemic, until the beginning of this year, the S&P Banks Index had generally been outperforming the broader market as government bond yields were growing higher across the entire yield curve. However, despite the Fed indicating they would be raising interest rates and shrinking their balance sheet faster than previously anticipated this year, banks have failed to keep the outperformance up. In fact, more recently we have seen bank stocks underperforming broader markets whilst the yield on the benchmark 10-year treasury index has climbed to 3.2% from 1.5% at the end of 2021.

Why is this important?

The chart illustrates the recent divergence between the two series which have previously moved strongly together, with banks trailing behind despite the tightening in financial conditions. Financial stocks can benefit from increasing interest rates through higher net interest income (the difference between income earned and income paid out). However, they benefit most from a steeper yield curve, as they can lend on the long end and borrow at the short end, pocketing in the spread, but this year short term rates have been rising faster than longer rates, which ended up hurting banks’ profitability.

A major factor in whether these stocks will stage a recovery will be how the Fed combats inflation, which is at its highest level in decades, and how the US yield curve moves as a consequence. The outlook still remains extremely uncertain, and we can’t be certain about future returns, but with lower share prices in the face of a rising interest rate environment coupled with robust profitability, metrics could result in a near-term opportunity.