The Investor Opportunity for Bank Stocks: Why They’re Falling As Interest Rates Rise

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Cast your mind back if you can, dear reader, to the spring of last year. We had lived through more than a decade of low interest rates, and a rising rate environment was a theoretical, almost mythical beast; something that our parents talked of in hushed tones but of which we had only a vague recollection, if any at all. Still, like winter, it was coming, we were told, and preparing for it was all the rage.

In my world of commentary and punditry, everyone was competing for an original way to do that. Underlying them all though, was the “obvious” rising rate play: buying bank and financial stocks. It became conventional wisdom that banks and insurance companies would be some of the few beneficiaries of rate hikes, and that investors could not just hide in the sector as the Fed acted, back actually make gains there.

The theory behind that idea is pretty simple. The traditional source of profit for banks is the spread between the rate at which they can borrow money and the rate at which they can lend it out. If rates are climbing, money that was borrowed cheaply can be lent out at higher interest rates, increasing profits. That, it seems, was fine in theory, but since the Fed confirmed their intention to start raising rates at the beginning of this year, traders have seen it differently. This is the chart for the financial sector ETF, XLF, from March 16, the day when Fed Chair Jay Powell announced the first rate hike in this series, until Friday’s close:

XLF chart

As you can see, despite that theoretical advantage for banks in a rising rate environment and after climbing for a couple of weeks on the news, XLF quickly turned tail and has lost 17.7% from its high at the end of March. For comparison, the Dow Jones Industrial average has lost around 12% in the same period. If you extended the chart back further in time you would see that XLF is trading at the same level as it was in February of 2021, around the time that preparation for rate hikes began. It has given up all the gains from being the “obvious” rising rate play.

So, are rising rates actually good for banks or not?

Well, yes, rising rates are good for banks in some ways, but there is a fear that the impact they will have on the broader economy will negate that benefit. You might think that inflation would encourage borrowing as household and corporate budgets tighten, but consumers and businesses are used to borrowing at low rates. If increases scare them away and reduce borrowing significantly, the increased spread available to banks won’t matter. In addition, there is the fear that the Fed’s response to inflation will push the economy into a recession, reducing the appetite for borrowing even further, and increasing default rates on existing loans.

Then there is the fact that for most banks, brokerage and investment services are a significant source of income. The drop in stocks will have discouraged investors, while also reducing the value of clients’ investment accounts. In a world where most brokers charge an annual fee based on a percentage of the value of the account rather than charging for transactions, that will inevitably hurt banks’ income from that side of their business.

When you look at all the potential downsides to the current environment for financial stocks in that way, the drop in XLF makes a bit more sense. The thing is, though, in the fearful atmosphere created by a volatile market those negatives are the only things that traders and investors have been looking at. They have been completely ignoring the very real upside to rising rates for banks.

That still exists, as a presentation by JP Morgan (JPM) at their investor day makes clear. In it, the firm said they now expect to hit a 17% return on equity by the end this year, after dropping that target in January. The reason for their returning optimism? Rising rates.

All things considered, this looks like the market doing what markets do, overreacting on the way up, then overreacting again on the way down. When the market was still feeling optimistic and traders were focused on looking for a sector that might benefit from rate hikes, financials soared; once the mood shifted and the focus moved with it, they collapsed and lost all those gains. However, as JP Morgan’s presentation makes clear, there are very real advantages to rising rates for banks. Stock prices in the sector at levels before those rate hikes were factored in therefore make no sense.

On that basis, financials represent a good opportunity for investors in a generally dangerous market, and should be among the first places investors looking to deploy capital on this drop look for bargains.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.



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