Is the Outlook for Banks Weakening or Still Getting Better?
Rising interest rates tend to propel bank profits. Bank stocks are up 24% since Trump’s election, but have underperformed by 700bps since the end of 2016. Bank profits depend both on net interest margins and on total loan volume, so recent data showing a decline in the pace of commercial loans in March and fewer mortgage refinancings are arousing concerns. On the flip side, interest rates are climbing, following two Fed rate increases in the last four months, and markets expect two more to come during 2017. So we remain in the early stages of interest rate recovery, which augers positively for banks.
Fed officials are once again discussing an impending effort to reduce the Federal Reserve’s $4.5 trillion balance sheet. Recall that the Fed shifted to buying longer maturity assets in order to reduce longer term interest rates to spur housing and capital investment. But as the economy has recovered and labor markets have tightened, such stimulus is no longer needed and, counterproductively, may reinforce inflation pressures from unemployment at 4.5%. If and when the Fed trims its holdings, longer term interest rates should rise.
The Fed appears likely to allow mortgage securities to roll off its balance sheet either as mortgages mature or as households choose to pay them off early, as they would when selling a home. The Fed would simply choose not to purchase new securities as replacements, which would reduce the supply of funds available. With fewer dollars available for mortgages (or mortgage-backed securities), the market would naturally need a rise in rates to attract new funding. These are longer term loans and so longer-term interest rates would be pushed higher. When the Fed raises the funds rate, that action directly affects short-term rates. So, the Fed needs to choose the mix between raising short-term rates versus long-term rates. Raising short term rates and reducing its balance sheet could be considered substitutes in meeting its mandate to control inflation. It appears we will see some of both this year. The Fed’s minutes last week point to a greater likelihood of both rising short term rates and a steepening of the yield curve as 2017 progresses.
Rising interest rates tend to increase bank profit margins, particularly those that rely heavily on checking deposits as sources of funds. Moreover, recent data indicate that banks are flush with deposits and so are likely to leave deposit rates at zero even if short term rates rise, at least for a while. Consumers also have fewer options to seek positive returns and maintain short-term liquidity through money market funds since changes in regulations since the crisis curtailed their availability.
But what of slowing loan growth? One explanation may lie in the efforts by firms to adjust debt positions in advance of the coming increase in rates, and in particular, of a steepening yield curve. Companies have the incentive to lock in currently low long-term rates before they increase. The cash that is raised can be used to pay down credit lines. Bank loan volume data report the paydown of these bank lines, which implies that loan demand is weak, but that misses the high level of borrowing in the bond market. CFOs are likely to continue to take advantage of the market’s seeming reluctance to acknowledge coming rate increases and get those rates locked in while they can. But this is a temporary headwind to firms’ use of short-term lending.
Banks are well positioned for rising rates. Banks benefit from rising lending rates that are not offset by increases in deposit rates, so their net interest margins will expand. The continuing solid economic recovery is likely to support growing loan volumes. Credit quality in the mortgage market remains high and household formation is likely to continue to move back towards longer term averages. All of these factors should offset the negative impact of rising rates on mortgage issuance. And as last week’s commentary discussed, loans in the automotive segment are far less sensitive to credit quality issues than most realize. In addition, as household balance sheets continue to strengthen with the ongoing recovery, look for expanded spending and further use of consumer credit. The US economy remains solid. Even the recent jobs report, with numbers coming in lower than expected, was reasonable with the 3 month average still at a healthy 178,000. While this is slower than the past few years, it’s still about double what is needed to simply maintain the current level of employment. All of those point to greater potential for banks to outperform, despite the very recent underperformance in shares.
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