How The Banking Sector Could Be Affected From The Fed's Inability To Tame The Fed Funds Rate

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About: Fidelity MSCI Financials Index ETF (FNCL)
by: Sankalp Soni
Summary

The Flattened yield curve is suppressing the performance of the financial sector and consequently, the VFH ETF.

A further narrowing in the spread between the IOER and ON RRP could aggravate Fed funds liquidity concerns for financial depository institutions.

The performance of the financial sector remains highly dependent on how the Fed approaches monetary policy going forward.

The Fidelity MSCI Financials ETF (FNCL), which tracks stocks of the US financial sector, is down 18.41% from its 52-week high. The flattening yield curve as a result of aggressive tightening by the Fed throughout 2018 has dampened investor sentiment towards the financial sector, as markets perceive that banks' ability to generate earnings is suppressed. Though, lately, the Fed has been struggling to keep the effective Fed funds rate at the desired level, closer to the mid-point of the range. If the Fed persistently fails to bring the Fed funds rate under control, then it could be forced to slowdown, or even halt, the tightening process. This could potentially help steepen the yield curve and improve the outlook for banks' earnings.

Source: Yahoo Finance

Prospectus Review:

The FNCL ETF tracks the performance of the MSCI USA IMI Financials Index as its underlying benchmark. The fund's management uses a sampling indexing strategy, whereby it may not invest in all of the securities in the underlying index but may choose to invest in a 'sample' of securities that the management believes represents the benchmark adequately based on fundamental and liquidity characteristics.

The top 10 holdings of the fund are:

This fund is one of the cheapest ETFs to offer exposure to the US financial sector. It has an average net expense ratio of 0.08%, considerably lower than the 0.38% average of all other ETFs that offer exposure to the same sector.

Risk note from FNCL prospectus:

The performance of the fund and its underlying index may vary somewhat due to factors such as fees and expenses of the fund, transaction costs, sample selection, regulatory restrictions, and timing differences associated with additions to and deletions from the index.

Below you can find a summary of the tracking differences between the FNCL market return and the underlying benchmark:

Source: Fidelity

Out of all the ETFs that offer exposure to the financial sector, this ETF has one of the highest Assets Under Management (AUM), currently standing at around $1.04 million, according to data from ETFdb.com. This makes it one of the 'Top 10' ETFs to offer exposure to the financial sector. I consider AUM as a good indicator of how successful the fund has been in implementing its strategy to deliver on its objectives for investors. The higher its AUM, the more investors have allocated their capital towards the fund due to effective management.

IOER and ON RRP

In my last article named 'VFH: Fed funds rate Rising Too Far, The Fed Could Be Forced To Halt Rate Hikes', I explained how the Fed seeks to control the upper bound of the Fed funds rate range through manipulating the Interest on Excess Reserves (IOER) and is currently struggling to bring the effective Fed funds rate lower to the mid-point of the range. Now, let us understand how the Fed controls the lower bound of the range before we get to how the Fed's tools could be limited in terms of dealing with a higher Fed funds rate.

The Fed sets the lower bound of its range by adjusting the Overnight Reverse Repurchase (ON RRP) rate. Reverse Repurchases involve the Fed selling Treasury securities to US depository institutions, and then buying those securities back the next day at a higher price. The difference between the selling price and buying price overnight is referred to the 'rate' that the Fed is willing to pay. Thus, the Fed sets a specific ON RRP rate that reflects the maximum rate the central bank is willing to pay on Reverse Repurchase agreements (reverse repos). Given that these transactions are backed up by highly liquid collateral, treasury securities, the rate, which banks earn from these transactions, is considered essentially risk-free. Therefore, the notion is that these US depository institutions will be unwilling to lend to other institutions at a rate lower than the ON RRP offered by the Fed and will want to charge a comparatively higher Fed funds rate when lending out its excess reserves, to compensate for the higher risks incurred compared to risk-free reverse repos. Hence, the ON RRP rate serves as the lower bound of the Fed funds rate range.

With the Fed having cut the IOER rate twice in 2018, the spread between the OEIR and ON RRP is now 15 basis points. The Fed's intention by cutting the IOER rate is to encourage depository institutions to lend their reserves to other banks that are in need of Fed funds and thereby, help bring down the Fed funds rate by increasing the supply of funds available. However, the outcomes could differ from what the Fed is aiming to do. Strategists are warning that further reductions in the IOER rate may instead encourage banks to withdraw reserves and invest in other short-term securities in money markets that offer higher yields.

Moreover, the Trump administration's fiscal expansionary has led to increased treasury bills issuance, which has caused Treasury yields to jump. Hence, with Treasury bill yields moving higher, banks may decide to allocate funds towards these money market securities, as opposed to making loans in the Fed funds market. Hence, if more banks decide to withdraw excess reserves to invest in alternative instruments, then it may become more challenging for institutions in need of short-term funds to borrow money on the Fed funds market and induce the Fed funds rate to move higher to compete with higher Treasury yields.

Therefore, keep in mind that the success of the Fed's monetary policy actions is highly dependent on banks' behaviour and that these depository institutions may not always react to policy changes in the manner that the Fed intends or anticipates.

The Fed will not be able to cut the IOER indefinitely because a further narrowing in the spread between the IOER and ON RRP may have unintended consequences, as explained earlier.

What Could The Fed Do Next?

With the effective Fed funds rate currently the same level as the IOER, 2.40%, the Fed could decide to stop tweaking the IOER as a means to drive the Fed funds rate lower, as it realizes its ineffectiveness in doing so. Keep in mind that the IOER that financial institutions earn on their deposits actually contributes towards the banks' Net Interest Income (NII). Hence cuts in the IOER actually undermine NII for banks, which could, in turn, suppress their profitability. Hence if the Fed decides to stop cutting the IOER going forward, then this would be a positive for banks as it would stop pressuring their ability to generate earnings from the spread between interest expenses (to customer deposits) and interest income from loans (including IOER).

In fact, if the Fed comes to the conclusion that it does not have the necessary tools to deal with the spiking Fed funds rate, then it could potentially decide to halt the monetary tightening process altogether. This would be a positive development for financial markets that have been beaten down by aggressive tightening and a flattened yield curve. Moreover, a more dovish approach from the Fed may actually help steepen the yield curve, which would improve the financial sector's earnings outlook, and thereby allow the FNCL ETF to rally higher.

On the other hand, the Fed could decide not to halt its tightening process, and could continue raising rates and unwinding its balance sheet regardless of the spiking Fed funds rate. Not only would this continue to flatten, or even invert, the yield curve, but could spark liquidity- related fears for US financial institutions. The rising Fed funds rate is reflecting institutions' difficulties in being able to borrow short-term funds. If the persistent decline in the excess reserve levels continues to lift the Fed funds rate higher, then certain banks may have difficulties complying with Liquidity Coverage Ratio (LCR) rules from Basel III. Furthermore, these liquidity issues could aggravate investors' perception of the financial sector and may lead to further downward pressure on the FNCL ETF.

Bottom Line

The FNCL ETF has been performing poorly over the past year amid aggressive monetary policy tightening and a flattening yield curve. Though investors should also pay close attention to developments in the ability of the Fed to keep the effective Fed funds rate under control, the spike in the rate closer to the upper bound of the set range reflects difficulties for certain financial institutions to borrow fed funds. The Fed could narrow the spread between the IOER and ON RRP too much which could lead to unintended consequences. The Fed could also make the mistake of continuing to tighten while the effective Fed funds rate continues to spike. There are several scenarios that could further hurt the financial sector. On the other hand, the Fed could potentially decide to halt the hiking process altogether this year if they believe they need more time to come up with more effective strategies to keep the Fed funds rate under better control. This would potentially be favorable for the financial sector and also help steepen the yield curve, or at least prevent it from flattening further. Thus investors should keep an eye out for further communication from the Fed when making judgments regarding future Fed funds rates and the shape of the yield curve, as the performance of the FNCL ETF is highly dependent on these factors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.