It’s the weather.
Whenever a weaker-than-expected economic report is released for a cold month, pundits always blame the weather. It’s become a cliché.
So when the Department of Labor released its disappointing January jobs report earlier this month, market observers quickly pointed to the bitter cold and inclement weather as the problem.
One surprising victim: the financial sector. The cold weather weakened the U.S. economy, at least for a time, indirectly creating headwinds for the financial sector’s ability to generate profits.
Yield Curve Profits
One way financial institutions produce earnings is by borrowing from other banks at lower rates than the rates they charge retail customers. For example, if a bank borrows at two-year rates and lends to a customer for their mortgage at 10-year rates they can theoretically capture the difference between the two rates.
A proxy for the profit margin that financials achieve can be measured by subtracting the 10-year yield from the two-year yield. The so-called “10-2 Spread” can be seen in the chart below. Theoretically, as the spread increases, profits increase. The reverse is true if the spread narrows.
So how would banking profits have declined because of the weather? From mid-January to mid-February, the harsh weather conditions led to a weakening in economic conditions consequently narrowing the yield curve.
The Institute of Supply Management’s (ISM) Manufacturing Report, which contains several key components, showed surprising drops in the Purchasing Managers’ Index, the New Orders Index and the Production Index. These disappointing results accelerated the narrowing in the yield curve.
According to the ISM, a number of comments from the report panelists cited adverse weather conditions as a factor negatively impacting their businesses in January.
As investors absorbed the magnitude of the change in the manufacturing sector, they began to buy 10-year bonds. That reduced the yield curve from a high at the end of December at 2.66% to a low on February 5 of 2.33%. The reduction in the spread could have cost a financial institution one-third of 1%, or about $3,300 on every $1 million in loans.
Sure enough, from January 15 to February 3, major financial stocks JPMorgan Chase (NYSE: JPM), Bank of America (NYSE: BAC), Wells Fargo (NYSE: WFC) and U.S. Bancorp (NYSE: USB) all shed between 4.25% and 8.25%.
A Change in Sentiment
But can all this really be blamed on Mother Nature? Many investors seem to think so, especially after the release of the ISM Services Report, which showed a surprising gain relative to expectations. Many believe that services are not affected by weather in the same way as manufacturing and construction.
History has shown that the stock prices of banks and brokerage houses rally when the yield curve steepens, and decline as the yield curve flattens.
But if the nasty weather is over, then a widening yield curve should follow. And, indeed, the yield curve has widened to 2.43% as of Feb. 18, 2014. Still, investors should be leery of earnings if the curve narrows further over the course of the first quarter of 2014.
View original at: Investment U
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