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The Federal Reserve is about to raise interest rates by 0.25%. This will be the eleventh straight rate increase from the Fed. Since banks make much of their money from the difference between long-term and short-term interest rates, the narrowing yield curve is hurting the earnings outlook for many banks. This has hurt smaller regional banks in particular because they tend to be more dependent on the yield curve for their profits.

One of my favorite banks, Commerce Bancorp, saw its shares take a big hit last Monday. The company said that earnings over the next two quarters will be below expectations. I still like the stock and I think market grossly overreacted. Commerce said it will only be two pennies a share below expectations. But this shows you that some investors are already afraid of the yield curve. The New York Times notes that in the past year, the yield spread between the two-year note the 10-year bond has closed from 168 basis points to just 26 basis points.

Here’s a chart showing the banking sector (black line) against the S&P 500 (gold line). While the banking sector has beaten the broad market over the past few years, the banks have started to lag the S&P 500 over the past few months. Once the Fed stops raising interest rates, and the yield curve widens, the banking sector could stage an impressive rally.

Posted by edelfenbein at September 20, 2005 1:48 PM