This article was originally published on TheStreet.com on September 26th, 2014 at 6:00am EST
There seems to be a general consensus among market commentators and investors that rising interest rates will be good for US banks. In anticipation, bank stocks like Bank of America (BAC), Citigroup (C), JPMorgan Chase (JPM), Wells Fargo (WFC), and the Financial Select Sector SPDR ETF (XLF) have had a tremendous run over the past two years.
It has been helpful that post-crisis litigation and fines seem to be in the rearview or at least out in the open, especially in the case of Bank of America and JPMorgan. But the recent rally for the group may be more of an opportunity for profit taking than confirmation of a trend.
First of all, the fact that rates are rising is debatable. Below is a chart reflecting the yield on our 10-year Treasury Bond over the past decade. Opinions will differ but to me the downtrend appears firmly intact:
The only time rates have risen meaningfully in the past few years was immediately following Bernanke’s infamous slap-on-the-wrist speech in May of 2013, warning investors that the QE spigot would assuredly not get stuck in the ‘on’ position. This was six months prior to the Fed actually beginning to slow its bond-buying stimulus efforts. Since Janet Yellen took over a year ago and QE has in fact been slowly and methodically withdrawn, rates have moved down across the board. Many investors banked too heavily on the Fed’s role in keeping the long end of the curve down.
Similarly, when the Fed does eventually tighten it will be raising short-term rates, and there is no guarantee that the downward pressure on longer-term rates will not persist. Two major catalysts remain:
1. The search for yield is now global, and for “risk free” yield the US Treasury Bond is the only game in town (where “town” is Earth).
2. Dollar strength means other currencies weakening in relative terms; Treasuries need not move at all, necessarily, for foreign buyers to profit by owning them.
So what has prompted the rally in bank stocks?
Has it been the idea that there was nowhere else to go but up? The strengthening U.S. economy and housing market? The shoring up of balance sheets and the tightening of lending standards?
Likely the artificially steep yield curve and the anticipation of higher rates are to thank. It’s not consumers who get access to 0% interest rates — it’s the banks.
But what seems to be getting overlooked is the fact that the spread — the difference between shorter and longer rates — is starting to narrow, and in somewhat dramatic fashion.
Banks are no longer savings and loan institutions, and have diverse portfolios of businesses, but at their core they make money by borrowing on the short-end of the curve (fed funds rate) and lending on the long-end (mortgages, commercial loans, etc.). Over the last fifteen years, here is how the Financial Select Sector SPDR ETF (XLF) has performed overlaid with the spread between the 2- and 10-year Treasury yield. You can see there is a bit of a lag in either direction but the correlation is quite clear: small spread = bad news for banks.
There are other factors influencing some US banks in particular. In my view Bank of America (BAC) and Citigroup (C) are the most notable exceptions to the argument outlined here. The resumption of capital return programs (dividends and share buybacks) at these two may provide significant support for their shares in the face of headwinds. Margin pressures on the group as a whole, though, may make for some unexpected turbulence at JPMorgan (JPM), Wells Fargo (WFC), and the Financial Select Sector SPDR ETF (XLF). Their respective dividends: 2.80%, 2.70%, and 1.50% do not adequately reward shareholders for risk that is yet to be priced in.
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Adam B. Scott
Argyle Capital Partners, LLC
10100 Santa Monica Blvd, #300
Los Angeles, CA 90067
(310) 772-2201 – Main
Adam Scott’s profile on TheStreet.com can be found here.