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Will Bank Stocks Get Extra Juice From a Fed Rate Hike?

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December 15, 2015
Bank stocks and juicy interest rates

Bank stocks were hard-hit in the wake of the global financial crisis, a blow that left many still struggling in the early years of the economic recovery and through a stricter post-crisis regulatory environment. And now? Enter the Federal Reserve.

As traders sit on edge waiting for Wednesday's Fed interest rate policy announcement, new light shines on these banking stocks. Could a rising interest rate environment potentially prove a boon?

A traditional model for bank revenues includes the profit margin, or spread, on what the bank pays depositors versus the rate it can charge consumers for loans. A rising rate environment could allow banks to reap higher revenues on that spread, as they may be able to loan money out at higher rates.

Since the Great Recession, changes in the regulatory environment and the low level of interest rates have forced banks to manage expenses and identify new sources of revenues, a shift from their traditional formula. "They’ve largely done a good job. Now, if they add in the new revenues from traditional banking functions, some could potentially be in for a nice revenue run over the next few years, all else being equal," says JJ Kinahan, chief market strategist at TD Ameritrade.

Time Will Tell

In the past, bank stocks underperformed the overall market while the Fed raised short-term interest rates, according to S&P Capital IQ data.

"That’s because rising short-term interest rates, combined with stable long-term rates, have almost always led to narrower net interest spreads, which is the profit rate that banks make on loans,” says Erik Oja, S&P Capital IQ’s banking analyst. “Once the Fed has finished hiking short-term rates, however, long-term rates have typically risen, leading to wider net interest rate spreads, and [historically] bank stock outperformance."

It’s always important to remember that stock market history has no guarantee of repeat. For one thing, other factors, including global economic instability, could continue to impact banking shares.

Position of Bank Assets Matters

This hiking cycle could be different, some industry analysts claim, because banks have had to position their revenue structures and balance sheets differently in the wake of the Great Recession because of global banking reform known as the Basel III capital rules and liquidity requirements.

The largest banks have significant assets in federal funds securities and other extremely low-yielding investments, explains Capital IQ’s Oja, who suggests that regional banks could also benefit from rising short-term rates.

Now, it’s also true that the stock market has had a long time to mull over that scenario.

Kinahan warns: "The key question is how much of this interest rate move is already baked into stock prices.”

The impact could vary depending on the type of lending institution. For instance, there could be conflicting headwinds for money center banks with large mortgage business segments. "We may see a temporary jolt lower to mortgage applications,” Kinahan suggests. “This will still be a shock to the system and there could be little or slightly downward reaction to the initial Fed news.”

TD Ameritrade clients can do their homework on banking sector stocks using the stock hacker tools (figure 1).

"You can see which banking stock has performed best leading up to the event, or which is exposed most to mortgages. Screen by business model,” Kinahan says. 

stock hacker tools

FIGURE 1: FILTER YOUR VIEW.

Log on to the thinkorswim® platform. Go to the Scan tab > Stock Hacker > Scan in and select “S&P 500.” Next click “Intersect with” and select Financials > Banks. Then click “Scan.” Not a recommendation. For illustrative purposes only. Past performance does not guarantee future results.

Join Us: Figuring Out the Fed

TD Ameritrade’s JJ Kinahan and Craig Laffman will huddle pre-Fed decision on Wednesday, December 16, at 9 a.m. Eastern, to discuss the potential impact of rising rates.