US Sector Showcase: Fed rate hike 100% priced in, but dots will still drive banks

Two weeks after the surprising US Presidential election, a clear narrative has emerged among traders, namely that President-elect Trump's vows to cut taxes and increase infrastructure spending will boost both the economy and markets.

 As the calendar flips to December, financial media outlets will no doubt begin obsessing over the Federal Reserve's highly-anticipated policy meeting on December 14th. Traders, however, have seemingly already made up their mind about what to expect; according to the CME's FedWatch tool, fed funds futures traders are already pricing in a 100% likelihood of a interest rate increase.

Assuming we don't get any massive surprises, the Federal Reserve's Summary of Economic Projections (SEP), where the central bankers lay out their expectations for future growth and interest rates, will actually be more important than the actual change to monetary policy. In other words, the "dots" will likely trump the decision.

From a US sector perspective, the most important stocks to watch around the Fed meeting will be the banks (XLF). In general, traditional banks make money by borrowing funds on a short-term basis (often in the form of customer deposits) and lending funds out on a longer-term basis. This is the basis for bankers' tongue-in-cheek "3-6-3 Rule": Borrow money at 3%, lend it out at 3%, and hit the golf course by 3pm. Therefore, when the yield curve steepens (meaning long-term interest rates are rising faster than short-term interest rates), financial stocks tend to outperform.

The chart below, highlighting the relationship between the relative performance of financial stocks (XLF/SPY) and the yield curve (2yr-10yr), highlights this relationship:

Source: Stockcharts.com

Even if the immediate result of next month's Federal Reserve monetary policy meeting is a foregone conclusion, traders should still tune it to see how it impacts the yield curve, and by extension, financial stocks. Readers with a strong conviction about whether the Fed will be more hawkish or dovish than expectations should consider trading bank stocks to express that thesis.