Banks Surge On Inflationist Dream Scenario

 

If 2020 was a nightmare, 2021 may be a dream scenario for banks. The bullish party kicked off following last night’s election results in Georgia that appeared to hand the Democrats the Senate. The idea of a unified legislative and executive branch sent bond yields surging today as the embers of inflation get stoked. Clearly, the market is expecting a further blending of fiscal and monetary policy and financials appear to have won the inflation sweepstakes.

Banks and Inflation

You may be wondering why banks like inflation. The correlation is rooted in the yield curve. Since the Federal Reserve sets the rate at which banks can lend overnight, banks can get access to capital for virtually nothing. This is because the Fed lowered rates to zero last year.

 

The question about bank profitability lies in their ability to lend at a higher rate than they borrow. This margin is referred to as “net interest margin (NIM).” Every earnings, banks report their NIM and their net interest income (NII) and it gives you a sense of the state of lending profitability. Thus, lower borrowing costs for banks and higher rates for borrowers mean more money for banks.

Banks and the Yield Curve

U.S. Treasury yields represent the risk-free rate, and the term structure of the Treasury market is represented by the yield curve. The Fed has the greatest influence on short term Treasury yields and inflation impacts long-term Treasury yields. With the Fed setting rates at zero and inflation causing long-term bonds to sell-off, the yield curve is steepening and the NIM is looking to expand.

The chart below is of the 10-year U.S. Treasury note yield. Since the outset of the pandemic, the 10-year only traded above 1% briefly on March 18 and March 19, 2020. That was after the Fed stepped in aggressively with some of the additional bond buying programs. The yield closed above that threshold today, finishing at 1.04%.

Today’s sell-off is a major event for banks and the market. The higher yields will help the NIM for banks but may cause the valuation of companies to fall with a higher discount rate. The tightrope for the Fed is to walk a line of higher inflation expectations without blowing out long-term yields. This is where the pressure to institute yield curve control will begin to mount.

Banks and Unusual Option Activity

Several banking and financials ETFs finished strongly higher. The SPDR S&P Regional Banking ETF (NYSEARCA: KRE) finished 7.81% higher and the Financial Select Sector SPDR Fund (NYSEARCA: XLF) closed 4.42% higher. The outperformance of regional banks makes sense since they are more lending focused and benefits more by a steepening of the yield curve.

However, the options market took aim at XLF today with some large bullish trades. Call option volume was blistering at over 4.4 ties the 5-day average. Over 51% of the call volume filled at the ask, which is indicative of call option buying. Here is a breakdown of the significant activity:

• 10,000 12 FEB 21 $31 calls BOT quickly @ $0.73 to $0.76 against open interest of 177
• 50,000 29 JAN 21 $31.50 calls BOT in one print @ $0.38 against open interest of 125
• 50,000 29 JAN 21 $33 calls sold in one print @ $0.39 against open interest of 36

The trading on the February expiration is just a straight call option with expectations of XLF trading above $31 in the next month. The January expirations is a long call vertical trade. The trade filled in one print and represents an expected move above $33 in the next few weeks.

XLF Technicals

The share price of XLF is approaching the 52-week high of $31.38. The option activity reflects an expectation that the high will be taken out by the end of the month. The thought of that happening is extraordinary, however, if the market is going to continue higher, it will need banks and financials to lead the way.

Conclusion

The bull market run is very long in the tooth. However, the movement in banks indicates that it may have a little more left. While the longer-term prospects of the market aren’t all that positive, the near-term potential of banks and high short-interest names is there. Maybe inflation really can draw blood from a turnip.