Financials, Interest Rates, and Coin Flips
“The financial sector moves with interest rates. It is poised to benefit from rising interest rates and will be punished should rates continue to fall.” – Investing Folklore
Long-term interest rates have fallen sharply in 2016, the yield curve has flattened, and Financials are the worst performing sector in the S&P 500.
Coincidence? Most would say no, as the standard talking points are that higher rates and a steeper yield curve are “good” for Financials while the opposite conditions are the bane of their existence.
But how accurate are these statements? Are they rooted in fact or folklore?
Let’s take a look at the historical data.
Going back to 1990, the monthly correlation between the S&P 500 Financials sector and the U.S. 10-Year Treasury Yield is .04. What does this mean in plain English? There is no consistent relationship between Financials and yields over the past 26+ years.
While there certainly have been many years where Financials and U.S. yields have moved in the same direction (2005 through 2009), there are also many years where they have moved in opposite directions (1990 through 1995). In fact, going back in 1990, they have actually moved in opposite directions more often (56% of years).
What about the U.S. Yield Curve (10-Year yield minus 2-Year yield)? Surely there’s a strong relationship there, right?
No. The monthly correlation since 1990 is .01.
(Note: for our research on Treasury bonds, click here).
Similar to the 10-year yield, we actually find that there were more years (56%) in which the yield curve moved in the opposite direction to Financials.
Thus far we have only looked at Financials on an absolute basis. Perhaps on a relative basis (performance vs. the S&P 500) there exists a stronger relationship with yields/yield curve. Are Financials more likely to outperform when yields are rising and more likely to underperform when yields are falling?
Again, the answer is no. There is no statistically significant correlation between yields/yield curve and the relative performance of Financials.
Financials have had terrible years of relative performance when yields were rising (1990 and 1999) and had great years of relative performance when yields were falling (1991, 1992, 1995, 1997, 2000, and 2012). There were also weak years of relative performance when yields were falling (1998, 2007, 2008, and 2011) and strong years of relative performance when yields were rising (1996).
The same is true for a steepening/flattening yield curve. There are times when each has been associated with good/bad relative performance in Financials.
A Coin Flip
Given the historical evidence, then, it would be hard to state that Financials are definitively going to move higher/outperform or move lower/underperform based on the direction of interest rates or the yield curve. But why do pundits continue to state without reservation that they will?
Because they are never asked to show the evidence behind their assertions and viewers like simple narratives when it comes to markets, whether they are true or not. That is not to say that interest rates are unimportant; they are very important. Financials very well could benefit from higher rates or a steeper yield curve in the years to come. But they could also be harmed or helped by other factors that have nothing to do with the direction of interest rates.
Interest rates and the yield curve are just two factors among many that affect the security prices of Financials in any given year. And based on the historical evidence, even if you could predict their direction going forward (which is no small feat) it would still be a coin flip in terms of predicting how Financials would perform. When it comes to investing, coin flips are not the best odds, which is why one would be wise to avoid making such predictions altogether.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
CHARLIE BILELLO, CMT
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
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