Investors are hoping financial stocks will benefit from rising interest rates. But it’s a complicated calculus. If the Fed is serious about aggressively tightening monetary policy, that could backfire on the big banks.
The Fed is no longer expected to raise rates gradually. The consensus opinion among economists is that a series of quarter-point hikes will no longer cut it.
The Fed is behind the curve on inflation. It’s time for shock and awe.
After slashing rates to zero at the start of the pandemic in March 2020, the Fed held rates there until finally lifting them to a range of 0.25% to 0.5% in March.
But, according to futures trading on the Chicago Mercantile Exchange, investors are now pricing in a nearly 80% chance of a half-point hike at the Fed’s May meeting and about 55% odds of another half-point increase in June. There’s even a more than 30% probability of a three-quarters-of-a-point rate hike, to a range of 1.5% to 1.75%.
Bigger rate hikes could eat into corporate profits and lead to even more stock market volatility. Bank earnings could be hurt, too, because a slide on Wall Street could potentially lead to less demand for mergers and new stock sales. Wall Street giants rake in lucrative advisory fees from deals, initial public offerings and special purpose acquisition company (SPAC) listings.
The ripple effect of higher rates
An economic slowdown caused by substantially higher rates also could hurt demand for mortgages and other consumer loans.
Mortgage rates are now approaching 5% and could continue to climb along with longer-term Treasury bonds. The 10-year Treasury yield spiked to about 2.7% this week, the highest level since March 2019.
So any lift to lending profit margins could be offset by a drop in loan activity. People would be less likely to buy new homes in a real estate market that’s already become prohibitively expensive for many Americans.
The inversion of the yield curve also could hurt banks. With rates for shorter-term bonds — most notably the 2-year Treasury — briefly rising higher than the rates for the 10-year Treasury, that also could put a lid on profits for banks that need to pay higher short-term rates on deposits.
“The recent inversion of the curve has been an overhang for bank stocks, with uncertainties regarding revenue growth and credit,” said KBW managing director Christopher McGratty in a first-quarter earnings preview report. He specifically cited “the risk of elevated deposit costs.”
It also doesn’t help that an inverted yield curve tends to be a fairly reliable predictor of an eventual recession. It goes without saying that banks would not do well if the economy pulls back sharply.
All these worries are hurting bank stocks. Investors appear to be more nervous about an eventual pullback than excited by the potential short-term boost to lending profits.
Two exchange-traded funds that own shares of most of the top banks, the Financial Select Sector SPDR (XLF) and SPDR S&P Regional Banking (KRE) ETFs, are both down this year along with the broader market.
“Rising inflation and higher interest rates may lead to a US recession. The course of the pandemic may also change consumer behavior as we continue to move to a new normal,” said CFRA bank analyst Kenneth Leon in an earnings preview report.
“US households could be more frugal and conservative with using their credit cards or consumer loans. Uncertainties remain on the outlook for consumer and commercial loan activity as well as investment banking,” he added.
Inflation could get worse before it gets better
Surging prices are still a major problem for many consumers. The US government will make that painfully clear once again next week when it releases two key reports about inflation in March.
The Consumer Price Index will be released Tuesday morning. Economists are forecasting that the CPI numbers will show prices rose at an 8.3% clip over the past 12 months, according to Refinitiv. That would be up from February’s year-over-year increase of 7.9%, which was already a 40-year high.
And experts aren’t predicting much relief on the horizon just yet.
The inflation challenges are likely to get worse before prices start to come down. Stifel chief equity strategist Barry Bannister forecast in a recent report that the annualized increase for CPI will spike as high as 9% in the coming months, before finally beginning to subside in the third quarter.
Inflation is even more problematic at the wholesale level. The government’s producer price index, which measures prices for raw goods sold to businesses, surged 10% in the 12 months ending in February.
The fact that PPI is rising even more sharply than CPI could be a sign that businesses are either unable or unwilling to pass on all their higher costs to consumers. That could hurt profit margins going forward.
Monday: China inflation; UK manufacturing production
Tuesday: US consumer prices; earnings from CarMax (KMX) and Albertsons
Wednesday: US producer prices; earnings from JPMorgan Chase, Delta (DAL), BlackRock and Bed Bath & Beyond (BBBY)
Thursday: ECB interest rate decision; US weekly jobless claims: US retail sales; US consumer sentiment (U. of Michigan); earnings from Taiwan Semiconductor (TSM), UnitedHealth (UNH), Ericsson (ERIC), Citigroup, Wells Fargo, Morgan Stanley, Goldman Sachs, Rite Aid (RAD), US Bancorp, PNC, State Street and Ally Financial
Friday: Major stock and bond markets around the world closed for Good Friday