High conviction idea: Buy U.S. financials

The Fed has clearly pivoted. It indicated at its December FOMC meeting that, for all intents and purposes, it was done hiking and the “dot plot” is projecting three quarter-point rate cuts in 2024 against a soft landing backdrop. Fed Chair Jerome Powell was given ample opportunity to push back against the dovish narrative. Instead, he embraced it. He shrugged off concerns about easing financial conditions. He didn’t express concern about above trend growth in the economy. When asked about the “last mile” problem of reducing inflation to the Fed’s 2% target, he said, “We kind of assume it will get harder from here, but so far it hasn’t.”


The Fed pivot set off a bull steepener in the bond market, where yields fell (and bond prices rose) while the yield curve steepened. The historical evidence shows that the relative performance of bank stocks is correlated to the shape of the yield curve. There was some interruption of this relationship in 2016–2018 when the shares of banks surged when Trump was elected on the expectations of bank tax cuts, and another rally when tax cuts were passed in 2017. Otherwise, the relative performance of banks has been sensitive to the yield curve as they tend to borrow short and lend long. As a consequence, a steepening yield curve is bullish for lending margins.



The Fed pivot is the catalyst for my high conviction call to buy U.S. financials for potential outperformance.



Inevitable dovishness

The Fed’s dovish pivot was inevitable. Conditions are ripe for a bond market rally. Monetary conditions are tight, as measured by the Fed Funds rate (red line) above core CPI (blue line). The combination of falling CPI and the start of an easing cycle has historically been conducive to falling Treasury yields.



The current disinflationary environment should put downward pressure on real yields, which is correlated to the USD.



Putting it all together, falling real yields, or rising TIPS prices, will create tailwinds for the S&P 500.



In addition, equities should receive an additional boost from rising EPS estimates. Rising estimates will boost valuation by increasing the E in the forward P/E ratio. Falling yields will also enable P/E expansion as bonds become less competitive with stocks.




A focus of financials