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TORONTO, Feb 22 (Reuters) - Investor sentiment in Canadian banks has begun to sour ahead of earnings this week as short interest positions in the stocks have jumped and analysts have begun to get increasingly skittish about their prospects in a weakening Canadian economy.
Canadian financials have been the worst performing among the 10 major sectors on the benchmark stock index year-to-date and the sector has fallen nearly 5 percent in the last three months. Some investors now fear that the banks, a major component of the financial sector, could be in for more pain.
"The Canadian banking sector is under pressure due to tight net interest margins and slowing loan growth. When you look at the amount of leverage banks have on their balance sheets, they are a bit at risk right now," said Kevin Headland, director of capital markets & strategy at Manulife Asset Management.
Canada's three largest banks Royal Bank of Canada, Toronto-Dominion Bank and Bank of Nova Scotia, are among the top 20 most shorted stocks in Canada based on the latest Toronto Stock Exchange data released mid-February. Bank of Montreal, the No. 4 player, saw short positions in its stock jump significantly in the first two weeks of February.
U.S. short interest data on the banks paints a similar picture with short interest positions in Canada's largest bank, RBC having risen 47.5 percent over year-ago levels. In that same period, short interest positions in its rivals TD, Scotia, BMO and CIBC, have risen 82 percent, 42 percent, 41 percent, and 62 percent, respectively.
The pullback in oil prices, coupled with weak manufacturing data caused the Canadian economy to unexpectedly shrink by 0.2 percent in November. This has prompted speculation that the Bank of Canada will cut interest rates in March for the second time in six weeks.
After the central bank's 25 basis point rate cut in January, Canadian banks reluctantly cut their prime lending rates by 15 basis points. By not passing on the full rate cut to borrowers, the banks are trying to protect their net interest margins and safeguard profits.
Despite this, Macquarie analyst Jason Bilodeau warned last week that the bank's results are unlikely to offer much in terms of positive news.
"The actual results themselves may not be all that bad, but we expect the commentary regarding the outlook to ratchet down materially," he said in a note to clients, expressing concerns about softer housing and employment trends.
On Friday, U.S. brokerage firm Keefe, Bruyette & Woods cut its rating on the Canadian banking sector to "underweight" from "market weight."
"We believe consensus estimates for the banks are too high and the shares will be pressured during the year as the Street moves its estimates down," said Keefe analyst Brian Klock in a note. "While we admit that the strong dividend yields for these banks may help to provide some downside support, we do not see a positive catalyst for the group this year." (Reporting by Euan Rocha and John Tilak; Editing by Rosalind Russell)