Banks need credit spreads to widen, says Piper Jaffray technician

As major banks report quarterly earnings Friday morning, one technician sees a different test for the financials sector.

“We’re actually neutral the financials right now,” Craig Johnson, chief market technician at Piper Jaffray, told CNBC’s “Trading Nation” on Thursday. “We’ve been really watching that 2 to 10 spread. We need to see that widen out then it would be a really healthy sign.”

The 10-year/2-year U.S. Treasury spread has been narrowing since the wave of sell-offs in equities at the beginning of February. The spread hit a year-to-date high of 78 basis points on Feb. 9 but has since narrowed to 48 basis points.

A narrower credit spread represents a smaller difference in yield between the shorter-maturity 2-year bond and the longer-maturity 10-year bond. Wider credit spread often indicates bullish economic sentiment among investors.

“We agree with Craig that in the short run this is a neutral,” said Chad Morganlander, portfolio manager at Washington Crossing Advisers, during the same “Trading Nation” appearance. “Net interest margins are critical. You need to see … the steepening of the yield curve to see a gradual improvement on the top line for these financials.”

The greater the spread on banks’ net interest margin the higher their profitability.

While Johnson waits for improvement in the credit spread, he sees the technicals as still supportive for financials. The XLF financials ETF, he says, has pulled back to the uptrend support line established since the 2016 lows.

A closer look at J.P. Morgan shows off the potential in the broader sector. At about 12 percent of the index, it provides clues as to how the rest of the financials sector might swing through the rest of the year.

“It looks very similar to the XLF,” he said. “It’s pulled right back to support. Looks like it’s retesting it. Looks like it’s holding it. Looks like it’s a buy-in here from our perspective.”

Over the long run, Morganlander also sees plenty of upside for the sector. He counts the growth factors assisting the group.

“One, economic growth across the globe has been quite vibrant. Two, you also have credit trends, particularly, with the consumer that look also pretty stable and growing. Thirdly, you have deregulation that we believe will give a big earnings lift not only to 2018 but also to 2019,” said Morganlander.

Those tailwinds should continue to benefit the financials sector through to the end of the decade, he added.

The financials companies in the XLF ETF are expected to post an average 28 percent increase in earnings over fiscal 2018 and 10 percent in both 2019 and 2020.