Don't Expect The XLF Rally To Last

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About: Financial Select Sector SPDR ETF (XLF)
by: Mott Capital Management
Summary

XLF saw some large put buying on August 7.

Yield curve hurts the stocks in the sector.

The technical chart is showing a major divergence.

Someone is making a big bet that shares of Financial Select Sector SPDR (XLF) fall in the coming months. With interest rates plunging and spreads on the yield curve contracting, the bet seems to make a great deal of sense.

Put Buying

The $25 Put options for expiration on September 30 saw their open interest jump by over 52,000 contracts on August 8 to a total of around 57,500. Data for August 7 from Trade Alert reveals that there were two trades of 25,000 contracts, with both trades taking place on the ASK. It would indicate that the options were bought, a bet the XLF falls by expiration. Remember, options are not liquid like equities. Therefore, the seller of the put options was likely a market maker, and they can hedge away any risk from taking the other side of the trade.

The puts trade for a price of almost $0.48 per contract, and it would mean that the XLF would need to fall about 10% to $24.50 or lower for the trader to earn a profit if holding the puts until expiration. The bet is sizable with the total open interest having a dollar value of about $2.8 million.

Spreads Are Narrow

One reason why a trader may be making a bearish bet on the financial sector ETF is the contracting spreads of the yield curve. Remember, banks generate a tremendous amount of revenue from net interest income, and if spreads are contracting, that will pressure net interest income revenue.

Banks generate this revenue by borrowing short-term deposits at a low rate of interest. Then they will lend money to borrowers at a higher rate of interest for the longer term. That creates a spread to which the bank can generate revenue.

But with the yield curve narrowing in recent months, that spread is contracting. Therefore the potential revenue a bank can generate is shrinking. One measure of the yield curve spread is the 10-year yield minus the 2-year yield. The spread is currently just 12 basis points wide, and at nearly lowest level over the past year.

The next chart is one that I supply to my Reading The Market Subscribers on the Seeking Alpha Marketplace. It tracks changes in the yield curve over time. It shows how yields have moved dramatically lower over the past year and the transformation of a positive sloping yield curve to an inverted yield curve. The curve is inverted when the rates for short-dated maturities are higher than the rates for long-dated maturities.

Technical Take

The technical chart for the XLF currently looks very weak. The XLF has been unable to rise above technical resistance around $28.75 on a few occasions since the beginning of 2019. Also, since the end of April, the XLF has been trending higher. However, the relative strength index has been trending lower, which is a bearish divergence. It would indicate the ETF is in the process of reversing its current uptrend. Should the ETF begin to fall, its next significant level of technical support would not come until $25.25.

Risks

When it comes to options trades, the one drawback is that at times they are used for hedging purposes. There's always the chance that a firm or trader placed the bearish bet to hedge against losses from a potentially sizable long position. Additionally, should central banks and the Fed begin cutting interest rates in coming months aggressively, it could result in the yield curve steepening. Should that happen, it would be a positive for the bank sector and the XLF ETF.

There are plenty of reasons to be negative on the banks and as a result, the XLF ETF. The recent bearish option betting coupled with the current yield curve indicates the XLF is more likely to fall than to rise in the future.

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.

Additional disclosure: Mott Capital Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Upon request, the advisor will provide a list of all recommendations made during the past twelve months. Past performance is not indicative of future results.