Banking ETFs May Be Short Candidates In This Rate Environment

When short-term interest rates are higher than long-term interest rates like now, bank earnings usually suffer because banks borrow at short-term rates to lend at long-term rates. Washington Mutual (WM) and Citigroup (C) missed second-quarter earnings/revenue forecasts; others beat projections but with the help of lower earnings quality, according to analysts.

The market seems to be expecting the Federal Reserve to lower short-term rates quickly like it did in 1995, but the ECRI’s gauge of future inflation has not plunged like it did in 1995. So the Fed may not ease as quickly and the current inversion of the yield curve could persist longer, dragging down bank stocks more.

Thus, you may want to avoid banking exchange traded funds [ETFs] like the Financial Select Sector SPDR (XLF). Aggressive investors could try a short position or put options on the Regional Bank HOLDRs (RKH) but less so on the XLF since the big banks are not as dependent on loan margins.