At the end of 2015, the United States Federal Reserve raised benchmark interest rates a quarter percent for the first time in almost a decade. You might have thought this tectonic shift in interest rate policy would be a boon for financial stocks that earn interest on the large cash balances that they typically hold. But not so fast.

Traditional financial media have been jamming this theory down our throats for months, but profitable trading strategies are rarely so straightforward. In the aftermath of the rate hike, equities are down substantially. And the financials as a sector have fallen even further than global averages. But understanding the flawed reasoning behind this simplistic strategy isn't all that complicated.

The term "yield curve" describes different interest rates at different maturities for bonds and notes. Think of how the yield on the 3-month T-bill is different from the yield on the 30-year bond. That’s the “yield curve”. If interest rates are higher at longer-term maturities, this is called a "normal yield curve." If interest rates are lower at longer-term maturities, this is referred to as an "inverted yield curve."

normal-yield-curve


With a virtual zero-rate interest environment over the last decade, the yield curve has been fairly flat - though certainly "normal" with longer maturity bonds having somewhat higher yields than shorter maturity notes. Rewinding to the topic of financial stocks, many believed that the strength of earnings in this sector would improve with higher rates because banks could take advantage of an ascending yield curve and earn more on interest over the long term. However, that's an oversimplified analysis.

The yield curve is based partly on expectations of rate hikes in the future. So while the Fed increasing them on one occasion is certainly an important data point, there are others to consider. For example, if the US economy is expected to expand with increased manufacturing, services, and job growth, then further rate hikes could be anticipated to ensure that inflation is kept in check.

The problem is that aside from a relatively robust jobs report from December 2015, the US economy doesn't appear overall to be growing at a fast enough pace to warrant further rate hikes. In fact, there are some out there that would argue current economic conditions in the US may be indicating the potential for a recession - the type of low-growth environment that would usually accompany a rate cut. That’s partly why the yield curve has stayed relatively flat, and why financial stocks haven’t performed that well.

As of now, a better estimate for the future, especially with global stocks in free-fall, is that the Fed might be extremely cautious in the near future and likely wait for more positive signals from the economy before raising rates again. That means the yield curve could remain relatively flat in the foreseeable future and consequently dampen earnings gains for financial companies in the near term.

Please send any comments or questions to support@tastytrade.com. Pete Mulmat talks about yield curves on his tastytrade shows Futures Measures and Where Do I Start: Trading Futures with Katie. Specific episodes that cover yield curves can be found here and here.

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