Trading Strategies: Bonds will tell you all you need to know about banks


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Smart traders believe that the bond market has a better record at forecasting the economy than economists themselves. When stocks and bonds give off mixed signals, they usually turn to the bond market for the right call.

Right now, with central banks around the world holding short-term interest rates at coma-inducing low levels and longer-bond yields in decline, the message is not great. It is ironic because the central-bank plan is to wake up their economies. The bond market thinks they are failing.

More germane to the corporate-banking sector is the difference between short- and long-term rates as those long-term levels continue to sink. While low long-term rates may attract business to finance expansion and other business activities, banks find increasingly difficult to make any money making those loans.

Indeed, several big U.S. banks just reported weaker quarterly profits and put the blame squarely on the low-interest-rate environment. One look at the chart of any benchmark government-yield chart suggests that is not going to change any time soon.

Making it worse, there is little to no room to lower short-term rates to steepen the yield curve and give banks some breathing room. Should any central bank, specifically the U.S. Federal Reserve, actually raise rates, the curve would flatten even more.

The Stoxx Europe 600 Banks index has been in sharp decline for the past year (see Chart 1). From its July 2015 top, it is down roughly 40%, which is about twice the loss for the Stoxx 50 blue-chip index.

Technically, the declining trend is still intact, and few indicators from momentum to moving averages to support and resistance suggest that the bottom is in.

To be sure, the sector is still reeling in the wake of the Brexit vote in the United Kingdom. With other sectors recovering most if not all of their losses, it is reasonable to expect banks to continue to bounce with them. But the bounce so far has been anemic, as the banks index barely regained half its losses since the close before the vote. Therefore, what is not reasonable is to expect banks will suddenly turn on the afterburners to go from laggard to leader.

There is yet one more development in the bond market that suggests it has a weaker outlook than the economic bulls would like to believe. Yields on nearly one-third of all issued government debt are negative according to Citibank. People took notice when the benchmark 10-year bund in Germany recently dipped below 0%. And the entire yield curve in Switzerland — all the way out to the 50-year maturity — is now negative.

This is unprecedented, and it speaks to the market’s view that it is better to pay to own government debt than risk it anywhere else. This has happened at the same time the U.S.’s S&P 500

SPX, +0.43%

 broke out to the upside from its multi-year trading range.

The bottom line is that according to the markets, the environment is not good and trends are still down. That means any gains in European banks, whether due to figuring out their post-Brexit strategy or some other fundamental shift, are likely to come grudgingly and be unsustainable.

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