Hopes that financial stocks will break out of their two-year funk took a hit while the rest of the market erased most an early loss after weakening employment spurred speculation the Federal Reserve will have to stand pat on interest rates.
A 1.4% selloff in financial shares in the S&P 500 Index caught off guard investors who anticipated that tighter monetary policy as soon as this summer would bolster the outlook for earnings at banks and insurers. Short interest on the most- traded financial exchange-traded fund slid to 1% of shares outstanding, down from a high of 7% in January, data compiled by Markit and Bloomberg show.
The prospect for lower rates for longer sent Treasury yields plunging and weakened the dollar by the most in four months. The currency’s drop helped offset some of the damage in financials by boosting commodities and raw-materials shares, along with multinational consumer staples companies on speculation a weaker dollar will lift overseas profits.
Utility shares rose to a two-month high and briefly touched a record. Phone companies also advanced to help pare Friday’s losses, as investors turned to equities that have high rates of dividend payouts relative to their share prices. “Even though on the surface a very disappointing jobs report, there are some beneficiaries from that,” said Michael James, managing director of equity trading at Wedbush Securities in Los Angeles.
 “Anyone who benefits from a much lower dollar is having decent day today, certainly mitigating what you would think would be a much worse performance for the market.”
Lower interest rates and bond yields curb lenders’ earnings power and erode profits at insurers that make money by investing premiums in fixed-income products. The renewed threat to interest income comes as banks grapple with dwindling profits from trading services that’s sparked job cuts across the industry.
“People were betting strongly that there would be two or more rate hikes in 2016 and this morning has dampened those hopes,” said Jesse Lubarsky, a financial-stocks trader at Raymond James & Associates in New York. “The banks need the economy to be improving to achieve the loan growth needed and this may signal that not all is well. These stocks never like additional uncertainty around the Fed - that is what has happened.”
The S&P 500 fell 0.3% to 2,099.13 in New York, after losing as much as 1%, slipping from a seven- month high. The Dow Jones Industrial Average lost 31.50 points, or 0.2%, to 17,807.06, erasing most of a 149-point drop as Caterpillar’s 1.9% climb led a rebound. The Nasdaq Composite Index declined 0.6% to snap a seven-day rally, the longest in 15 months. About 7bn shares traded on US exchanges, in line with the three-month average.
At the start of the year, investors piled on short bets on the Financial Select Sector SPDR Fund, known as XLF, as markets were roiled amid worries that plunging crude prices would lead to losses from loans.
Bearish wagers on XLF reached the highest level in more than two years on January 20. Since then, investors have slashed short interest on XLF by about 85%, while financial companies staged a comeback of 21% from a February low through yesterday. The selling was deepest among banks and insurers. Goldman Sachs Group and JPMorgan Chase & Co fell at least 1.7%, while brokerages E*Trade Financial Corp and Charles Schwab Corp sank more than 5.1%. Real-estate companies provided the only bright spot among financials, as the prospect for lower interest rates bolstered the property sector.
MetLife and Prudential Financial dropped more than 3%. US insurers hold more than $3tn in bonds to help back obligations to policyholders. Fixed-income securities account for more than two-thirds of the industry’s investments.
MetLife, the largest US insurer by assets, is among companies that have been shifting the product mix and charging customers more for some guarantees to cushion against low interest rates.
Warren Buffett, who built Berkshire Hathaway by reinvesting premiums from insurance units, said at his annual shareholders meeting on April 30 that low bond yields have hurt the prospects of that strategy for the reinsurance industry. A report today showed employers in May added the fewest number of workers in almost six years. Smaller employment gains reduce the odds of a more pronounced upturn in household spending and economic growth after a poor start to the year. Federal Reserve officials will take into account more judicious hiring, at a time when corporate profits are on a downswing and global markets remain weak, as they consider whether to raise interest rates again.
“A lot of people were looking for a second quarter bounce in GDP after a deceleration in the first quarter and you have to ask if this continues whether we’re going into recession,” said Phil Orlando, who helps oversee $360bn as chief equity- market strategist at Federated Investors in New York. “Valuations are already excessive and that’s why the market’s down. This derails the consensus view.”
Expectations for higher rates this summer tumbled after the jobs report. Based on Fed funds futures, traders are now pricing in about a 28% chance of a Fed boost by July, down from 55% earlier, while odds for a June hike have fallen to 2% from 20%. The disappointing job gains undercut optimism that bolstered the S&P 500’s third-straight monthly increase in May amid speculation the world’s biggest economy could withstand a rate increase as soon as this month.
The gauge has reached levels that proved difficult to maintain in previous rallies. It lost momentum after surging 15% from a February low to an April 20 peak, before picking up pace in the second half of last month amid improving data.
Federal Reserve Governor Lael Brainard said in remarks on Friday the “sobering” employment report suggested the labor market has slowed, and she continued to warn against moving too quickly to raise interest rates. Chair Janet Yellen is scheduled to speak on Monday afternoon.
“Things are never as bad or as good as they seem,” said Michael Arone, the Boston-based chief investment strategist at State Street Global Advisors’ US intermediary business.
The firm oversees $2tn. “Fed futures are pricing in a decreasing probability for June and stocks probably don’t mind that scenario all that much. We’re moving away from this risk- on, risk-off formula to one that’s more Fed on, Fed off.”