Regional banks have continued their impressive recovery from their early May lows, which came on the heels of the second, third and fourth largest bank failures in U.S. history by deposit totals. The SPDR S&P Regional Banking ETF (KRE) rose nearly 5% on the day Tuesday, and is up nearly 20% from its low on May 4.
I built a pretty decent position in this ETF and select regional banks in April via covered call orders. But I would not be adding to this sector of the market after its run over the past month. The rebound seems like it needs a rest to consolidate and the key hurdles for regional banks remain firmly in place and in some regards the environment is worsening. If I owned straight equity, I would be cashing in some profits as it feels like this pitcher might have gone past his pitch count.
Banking to a large extent is based on borrowing short and lending long. The whole business model gets upended in those rare instances where the yield curve inverts. And despite the recent rise in this sector, the yield curve remains deeply inverted. The 3-month Treasury yields nearly 5.4% compared to the 3.7% yield available on the 10-year treasury. This is one of the biggest divergences since the early 80s and remains a key headwind for the financial sector.
In addition, conditions in the commercial real estate market continue to deteriorate especially in the office and retail spaces. This is important as regional banks supply approximately 70% of the loans to the CRE sector. Earlier this week, Park Hotels & Resorts Inc. (PK) said it will stop payments on $725 million worth of debt used to secure two of its hotels in San Francisco and that was scheduled to mature in November.
Management citied record high office vacancy rates and lower return to office projections as two reasons it was "turning in the keys" on these hospitality properties. To give an idea on how detrimental the impact from the aftermath of the pandemic has been in San Francisco, consider that in 2019 the office vacancy rate in the city by the bay was just 7% and San Francisco office space had some of the highest per square foot prices in the country. Today, approximately a third of the office space in the city is vacant. San Francisco is hardly alone in this situation; New York City, Chicago and other major business hubs are facing the same challenging environment.
Finally, it is quite possible, if not likely, the regional banking system will face additional regulations and congressional scrutiny in the aftermath of collapses of Silicon Valley, Signature and First Republic banks. This could include capital hikes of as much as 20% under new rules being prepared by U.S. regulators according to recent reports.
For these reasons, it is probably time for this pitcher to come out of the game after a strong outing over the past month.
