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There's a strange divergence brewing in the financials, and it could spell trouble for stocks

VIDEO4:3404:34
A divergence between bank stocks could spell trouble for the market
VIDEO4:3404:34
A divergence between bank stocks could spell trouble for the market

With interest rates on the rise, and the Federal Reserve announcing its latest rate hike this week, investors might expect financial stocks of all stripes to soar. That hasn't been the case this year.

The KRE, a regional bank-tracking ETF, has surged 9 percent this year. This stands in contrast to the XLF, a widely followed financial ETF which tracks the performance of the S&P 500 financial sector, down just more than 1 percent this year. The has risen just more than 4 percent year to date.

Market strategists say the divergence within this key group could bode poorly for the broader market.

Matt Maley, equity strategist at Miller Tabak, highlighted this trend in a recent note to clients. He said the trend became particularly prominent in May when losses by European banks accelerated.

"You start to worry about what kind of exposure they have there, and that's where the divergence really took place, where the KRE continued to rally nicely as we've moved into this month, but a stock like Citigroup has been making a series of lower highs and lower lows for some time now, and is now testing its trend line going back to 2016, " Maley said Wednesday on CNBC's "Trading Nation. "

"Especially with the yield curve getting flatter and flatter, this problem in the big ones could roll over into all the bank stocks before it's over," he added.

One reason the smaller banks have rallied so impressively this year has been the rise in small business confidence, said Boris Schlossberg, managing director of foreign exchange strategy at BK Asset Management.

Earlier this week the small business optimism index from the National Federation of Independent Business rose to its second-highest level in the gauge's 45-year history. Small banks should continue to rise, he said.

"Going forward, it's really going to depend on the strength of the U.S. economy. If the regional U.S. economy continues to perform as well in the second half, perhaps even better in the second half [of 2018] than the first half, I think the fundamentals are going to carry it forward," Schlossberg said Wednesday on "Trading Nation."