Monday, January 02, 2006

Betting on a Return to Normal Yield Curve through ETFs

Barron's, Jack Willoughby, 2 January 2006

Tired of second guessing the Federal Reserve Board on whether it will hike interest rates under new Chairman Ben Bernanke? Rest easy. Brian Rauscher, chief portfolio strategist at Brown Brothers Harriman, the New York private bank, has concocted a special New Year's cocktail mix of index ETFs that could allow you to profit as the yield curve twists.

"Our research has showed us that when the yield curve is at its steepest point, it pays to rotate from regional banks into diversified financials," says Rauscher, who developed Brown Brothers' proprietary system after moving from U.S. Trust. "Now, it's time to go the other way."

Normally, short-term interest rates are lower than long rates. The lower they are relative to long rates, the steeper the curve. But recently, long and short rates have been pressed together so tightly that there's almost no difference between them.

In fact, the curve was slightly inverted at week's end; the yield was 4.41% on the two-year Treasury, 4.39% on the 10-year. Financial shamans say that a flat or inverted yield curve anticipates a recession within one year or two. Modernist economists love to scoff at these old-time notions, arguing that the yield curve has lost its predictive value. (They're probably the same economists who have in prior epochs declared an end of the business cycle, the death of equities and the repeal of gravity.)

Rauscher is advocating a trading strategy that requires no forecasting of rates' direction. Instead, he says, you're simply "betting on the probability that interest rates will return to normal." And rates always do return to normal at some point. That's only, well, normal.

Here's how the strategy works. First you sell short the popular Financial Select Sector SPDR (XLF), an exchange-traded fund tied to the likes of Citigroup and Morgan Stanley. Then you plow the proceeds into an equivalent amount of Regional Bank HOLDRs (RKH). The idea is to keep these trades linked as a pair until the yield curve becomes steep once again -- a development that should help the regionals and hurt the big financials.

Right now, stocks of the big financials in the XLF are on the upswing, their diversified asset base and fee businesses favored by analysts. It's thought that they will weather a flat yield curve better than smaller, regional banks. But the prospects for the group may be overstated, according to Brown Brothers, which closely tracks earnings revisions to detect analyst sentiment. Roughly 34% of recent revisions for diversified financial companies in the S&P 1500 have been by analysts who see brighter prospects for them. That's a historically high level, and an oversupply of optimism often precedes a fall from grace.

In contrast, regional banks have fared worse, since they depend heavily on the difference between short-term rates, which they pay for deposits, and long-term rates, which they receive on their loans. RKH shares have fared poorly in the rising short-rate environment. Brown Brothers has found that 23% of rating revisions on banking companies were downward, indicating a severe lack of enthusiasm.

The widely varying performances of big financials and regional banks make Rauscher's bet attractive. In fact, the performance gap between the two hasn't been this wide since March 2000, when the tech bubble burst. (See chart.)

Once the strategy is in place, investors need only to wait for the yield curve to steepen. The short position in big financials will pay off as the sector's supposed advantage in a flat-curve environment becomes irrelevant. Likewise, the long position in regionals will be rewarded as the banks enjoy a fatter spread between their loan yields and deposit rates.

"This could well turn out to be an 18-month proposition, one with very little market risk," says Rauscher. "I'd anticipate keeping it on for a while." Of course, you could experience some pain if the yield curve continues to invert, but history shows that such periods are usually short-lived.