Larry,
could you explain the relationship, if any, between xlf and interest rates, especially the spread between short term and long term rates. Thanks,
h
Over half of the XLF holdings are banks and insurance companies. Banks basically make money by borrowing short and lending long. In other words, they borrow at the short term interest rate and lend at the long term interest rate. When short term rates are significantly lower than long term rates (a steep yield curve) banks do really well. In 2004, the net profit margin for big banks was 37%, compared to the S&P index, which was about 7.5%. However, when short term rates go up in relation to long term rates (a flattening yield curve), the profit margin for banks get squeezed. And when short term rates go above long term rates (an inverted yield curve) money gets really hard to come by.
Insurance companies use the premiums that they receive to buy financial instruments, mainly bonds. So they do much better in a strong bond market (lower long term rates).
The bottom line is that the XLF should do better if you think interest rates are coming down. It should struggle if you think rates are going up. I think the reason that it’s been doing well lately is that it’s discounting the expectation that the Fed only has one or two interest rate hikes left.