KBE ETF: Banks Outperform As Rates Rise, New Market Leadership Possible

Will it be 75 or 100? All eyes are on the Fed this week ahead of the FOMC’s crucial interest rate decision on Wednesday. Currently, traders have priced in an 82% chance of a 0.75 percentage point hike, but no one should be surprised if that’s the case a full percentage point increase will be announced this week.

Fed Funds Probabilities: A 0.75 percentage point hike likely

In retrospect, investors have suffered sharp losses over the past month as the market grapples with the fact that the Fed is steadfast in its efforts to cool inflation. Powell’s “painful” message in Jackson Hole last month was met with volatility, but stocks rebounded in early September. While it feels like ages ago, it was only Monday of last week when the S&P 500 topped 4100 and gained 6% in just a handful of sessions.

S&P 500 YTD: Stocks down 10% MoM

Then came Tuesday morning’s CPI report, which revealed an unexpected rise in core inflation. While consumer prices have been tame over the past two months, inflation excluding food and energy continues to rise at an uncomfortable pace. At least in the Fed’s hawkish eyes.

A growing number of pundits are concerned that the central bank committee could end up on a “too aggressive” path that could result in a deeper recession than was thought just a month ago. Consider that fed funds futures have discounted a final rate of nearly 4.45% through April 2023 — who knows what the economy might be like by then. In addition, it is regularly said that it takes at least six months for rate hikes to feed through to the broader economy.

Some forecasters from the investment banks already see increasing recession risks for the next year. Bank of America is forecasting job losses for much of the second and third quarters of 2023, with the unemployment rate rising to 5%. There is a positive side to this bleak outlook, however, as it means that inflation would almost certainly return to the Fed’s target level.

A slowdown turning into a recession?

With stocks down 10% over the past month and interest rates up dramatically, there seems little room to hide. I see some hope in one of the hardest hit industries in the last decade – banking.

This seems counterintuitive given that the Treasury yield curve is as inverted as it has been since 2000, but the SPDR S&P Bank ETF (NYSEARCA:KBE) settled at a fresh six-month high against the S&P 500 on a weekly close basis on Friday. In fact, it has been in relative rally mode since early April.

Banks vs. S&P 500: Relative strength for much of 2022

For background, the SPDR S&P Bank ETF offers investors exposure to the following sub-sectors: wealth management and custodian banks, diversified banks, regional banks, other diversified financial services, and thrift and mortgage financing sub-sectors, as of SSGA Fund.

The ETF takes an equally weighted approach, making it effectively a mid-cap fund compared to other cap-weighted banking products. The portfolio has an expected price-to-earnings ratio of 10.0 with an expected EPS growth of its holdings of over 7%.

KBE portfolio

Another arrow in the bank bulls’ quiver is seasonality. Over the past 16 years to 2021, KBE has tended to post big gains from late September through year-end.

KBE seasonality: Bullish into year-end

The technical recording

KBE has relative strength in the near term as it settled last week well above the lows from earlier in the month. In the three-year chart below, note that the $42-$43 area is a crucial point. Although the level is well below the current share price, it must be maintained. If the ETF breaks out of $53, it could start a race back to its all-time high above $60 — which was a double top from the mid-2000s if you go back further.

I like how the downtrend that started in January was decisively broken in July. Obviously, nothing from the long side is safe in this environment, but if we see a Q4 rally given the bad sentiment, I think KBE could lead the way.

KBE: Downtrend broken, watch two key levels

The final result

With a good rating and relative strength, I contend that KBE is worth trying here. Bullish seasonal trends taking root later this month are another catalyst for potential upside. In principle, banks could offer a hedge against higher interest rates, as the deposit-taking institutions within the KBE portfolio should benefit from this new interest rate regime.