The financials and small cap stocks have started to make new all-time highs once again. XLF, the SPDR financial sector ETF, has made new highs since its peak in 2007. Because of this, our newsletter portfolios are going to add more exposure to the sector. The Russell 2000 is also reaching new highs, but this is likely because of the correlation the index has to the financial sector. Currently the correlation sits at a 0.96 out of 1.00, and it generally stays above 0.50.
The correlation to financials is not a coincidence. First, the financial sector has the highest weighting in the index. Another reason is that the companies in the index, small cap stocks, often rely on financial relationships with the banks within the sector. It is often seen that the economy is as strong as its banks. In order for small cap stocks to do monetary transactions, they need to rely on America's financial institutions. If they need financing or a line of credit, they go to a bank. Remember that correlation does not mean causation. Banks also rely on the smaller companies for revenue as well.
So, why are these two segments of the market making new highs?
Hope In Congress
The small cap stocks are likely making new highs because of political hopes. Since the Trump Administration released its tax plan, the markets are hoping that congress will be able to get tax reform done. It was a major promise of the Trump campaign, and it could really help the economy, but there are many investors that are waiting to see if anything will get passed before investing their cash. Since healthcare reform has failed to make any strides towards “repeal and replace”, and an infrastructure bill has not been passed, some investors caution that tax reform may be facing the same hurdles. If tax reform can get done, we may see stocks move up quickly, especially the small caps and financials.
Interest Rates
The rise of the 10-year treasury note means that the financial companies can charge more to lend capital to individuals and companies. Mortgages, business loans, even credit cards become more profitable as the 10-year treasury moves up.
The interest rate for borrowing capital is determined first by the risk-free rate. The risk-free rate is usually the rate an investor can receive on a T-Bill (Treasury Bill). Interest is then added on to the borrower, based on the amount of risk the lender is taking. They will consider risks such as the amount of money borrowed, the time it takes to be paid back, and the borrower’s credit score.
While the T-Bill is not completely risk free, it is considered risk-free because it is backed by the US government. Because the government can print money as it pleases, it is very hard to see a reason why it would not pay back its debt. The only reasons could be because congress fails to raise the debt ceiling and the government defaults on its obligations, or if the US government disappears. Of course, no one is expecting the US government to disappear anytime soon. Since defaulting is political suicide and highly irrational it is not likely the government will fail to make its payments either. The ramifications would be so large, and hurt the world economy, that it makes no sense to default.
Unfortunately though, today the debt ceiling is used as a political weapon. In fact, because politics have made it hard on borrowers, credit rating agencies in 2011 downgraded the US from an “outstanding” borrower to an “excellent” borrower. This affects more than the US government though. Because the government needs to pay more interest, the risk-free rate has risen, making borrowers pay more as well.
Why Are Interest Rates Rising?
Interest rates change for two reasons. The first is that the Federal Reserve can influence the treasury yields, causing the risk-free...
Visit http://ift.tt/2wGemuL to read the rest of the article!
Submitted October 08, 2017 at 01:25PM by BR-Technicals http://ift.tt/2g4NYYd
No comments:
Post a Comment