RISING RATES AREN'T GOOD FOR FINANCIALS

FINANCIAL ETF UP AGAINST RESISTANCE ... Earlier today I showed the Nasdaq Composite testing overhead resistance formed at the start of the year and in an overbought condition. I suggested that might be enough to cause some profit-taking. Financial stocks are in a somewhat similar situation. Chart 1 shows that the Financials Select SPDR (XLE) has reached resistance formed during the first quarter of the year around 30.25. Its 9-day RSI is also starting to weaken from overbought territory above 70. The two lines below the price chart may also carry a warning for the financial group. The first line is a ratio of the XLF divided by the S&P 500. It's starting to weaken which shows that the financial group is starting to show relative weakness. The bottom line may explain why that's happening. It's a chart of the 10-year T-note yield which has just risen to a two-month high. Financial stocks normally don't do very well when long-term rates are rising. That's demonstrated in the next three charts.

Chart 1

2000 PEAK IN RATES HELPED FINANCIALS ... The purpose of the next three charts is to show that the relative performance of the financial sector is largely determined by the direction of long-term rates. The green line in all three is the 10-year T-note yield. The purple line is a ratio of the XLF divided by the S&P 500. Chart 2 shows a that a major upturn in the XLF/SPX ratio coincided with a major peak in bond yields at the start of 2000. The outperformance by financial stocks lasted to the start of 2004 until long-term rates starting rising. That early 2004 turn is seen more clearly in Chart 3. Notice that the peak (red arrow) in the financial/S&P relative strength line in the spring of 2004 coincided with an upside spike in the 10-year T-note yield (red circle). Since that early 2004 trough in rates, financials have underperformed the S&P 500. A peak in rates in the spring of this year (green circle) gave a temporary lift to financial stocks (green arrow). Chart 4 shows why that may be ending.

Chart 2

Chart 3

RISING RATES THREATEN FINANCIAL LEADERSHIP ... Chart 4 compares the trend of the 10-year T-note yield (green line) to the XLF/S&P ratio (purple line) since the start of 2005. A clear inverse relationship is seen. A spike in bond yields in February (first green arrow) coincided with a peak in the ratio line. A sharp drop in yields starting in April (second green arrow) pushed the financial relative strength ratio higher. Since the start of July, however, the 10-year yield has climbed to a two-month high. As a result, the financials appear to be losing their relative edge. It's not clear whether or not the latest upturn in bond yields is for real. There have been a lot of false starts over the last year. Last week's decision by the Chinese to revalue the yuan, however, may be one of the factors starting to push bond yields higher. If yields do start to head higher, financials will be one of the more vulnerable stock groups. Some selling is starting to appear in housing stocks which are also vulnerable to rising long-term rates. We'll take a look at that rate-sensitive group tomorrow.

Chart 4