Financial issues were weighing on the market midday Monday, as investors were positioning themselves ahead of another expected Fed rate hike next week.

In recent trading, both the S&P financial sector index and the Amex Broker/Dealer Index were losing 0.4%, albeit up from earlier lows.

Weakness in financials such as AIG ( AIG), American Express ( AXP) and J.P. Morgan Chase ( JPM) also was weighing on blue chips. The Dow Jones Industrial Average was recently down 31.37 points, or 0.29%, to 10,846.14.

The broader market was hit as crude oil prices topped $60 per barrel for the first time since early November. The S&P 500 was recently down 2.68 points, or 0.21%, to 1262.40. The The Nasdaq Composite was down 14.24 points, or 0.63%, to 2259.13.

With the financial sector representing more than 20% of the S&P 500's market capitalization, it's an understatement to say that the sector's rally helped the market bounce from the October lows.

Financials have been the best-performing sector of the S&P since early October, rising 4% in the fourth quarter to date. The sector has risen another 1% in December, as of Friday's close.

The rally corresponded with a drop in long-bond yields in November -- from 4.66% in early November to 4.41% by the end of the month.

But as mentioned here , long-dated Treasury yields interrupted four weeks of declines last week. On Monday, the benchmark 10-year Treasury bond was recently down 10/32, while its yield was up to 4.55%.

The latest weakness in bonds followed the non-manufacturing survey by the Institute for Supply Management, which confirmed the strong economic outlook implied in recent data.

Rising long-term Treasury yields, which reflect inflation expectations, can be bad for financials by reducing the appetite for risk in the overall investment environment.

But things can get worse if the yield curve, which plots the yields of short- to longer-term bonds, flattens. Many financial firms, especially banks, profit from borrowing at cheaper short-term rates to lend at more profitable long-term rates.

Yet short-term rates, which react more directly to Fed rate hikes, have been rising as well. On Monday, the two-year note was losing 2/32 in price, while its yields rose to 4.46%. The spread between the note's yield and that of the 10-year bond stood at a very low 9 basis points.

The market fully expects the Fed to raise its key rate to 4.25% on Dec.13, almost fully expects another rate hike on Jan. 31, and is increasingly pricing in the chance of another hike on March 28, according to fed funds futures.

As noted by David Rosenberg, Merrill Lynch's chief economist, the S&P financials (before Monday) have been "behaving as if the Fed is done in two weeks."

But the sector and fed funds' futures "cannot both be right," he says.

Rosenberg's theory is that given the strong economic data lately -- especially a third-quarter GDP growth rate of 4.3% -- few in the market believe that an inversion of the yield curve is possible.

An inversion, when long-term yields fall below those of short-term ones, has often been an accurate predictor of economic recessions 12 months later.

When the yield curve last inverted in the second quarter of 2000, GDP growth was 6.4%, Rosenberg notes. When it inverted in the first quarter of 1989, growth was 4.1%, and when it did so in the fourth quarter of 1978, growth was 5.4%. "Just check out what the economy was doing a year later," the economist warns, "it was not a pretty picture."

There are other reasons to remain weary of financials in the short term. According to Citigroup market strategist Tobias Levkovich, there is a mistaken consensus in the market that the financial sector is cheap because its price-to-earnings ratio is fairly low. But, Levkovich notes, that's because many financial firms use debt as leverage, which weighs on their stock price.

As evidence that financials aren't cheap, he says, there hasn't been a pick-p in M&A activity within the overall sector this year. In 1995, 20% of all M&A activity in dollar terms came from the financial sector. So far this year, the sector's contribution is only 14.5%.

Levkovich says the recent run-up in financials' stock prices warrants a near-term pullback, but he is less bearish on the sector next year.

If the yields of 10-year Treasuries do indeed go down next year, as Citigroup's economists expect, that should work in favor of the banks especially. But Levkovich keeps a neutral (and market weight) stance on the banks given their current valuations and recent upward earnings revisions, which leave these stocks vulnerable to bad news.

He does have an overweight stance in diversified financials, though, which include investment banks, brokers and asset managers, including Merrill Lynch ( MER), Goldman Sachs ( GS) and Schwab ( SCH). Although, like banks, near-term weakness can be expected through the first quarter of 2006, this would be a good time to buy, he says.

Levkovich expects the overall stock market to rally in 2006 as the market starts anticipating the potential for Fed easing later in the year. This should boost equity commissions, improve underwriting margins and fee revenues.
In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback; click here to send him an email.

If you liked this article you might like

Fed Sparks Gold Rally

Fed Sparks Gold Rally

Metals Follow Stocks Higher

Metals Follow Stocks Higher

Gold Ends Cautious Session Lower

Gold Ends Cautious Session Lower

Gold Ends Session Lower

Gold Ends Session Lower

Gold Eases on Inflation Jitters

Gold Eases on Inflation Jitters