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

VSast your mind if you can, dear reader, in 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 about in whispers but that we had only a vague memory, if at all. Yet, like winter, it was coming, we were told, and preparing for it was all the rage.

In my world of commentaries and experts, everyone was fighting over an original way to do it. However, underlying all of this was the “obvious” game of rising rates: the buying of banking and financial stocks. It became the conventional wisdom that banks and insurance companies would be among the few beneficiaries of rate hikes, and that investors could not just hide in the sector while the Fed acted, but make gains there.

The theory behind this idea is quite 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. If rates rise, money borrowed cheaply can be loaned out at higher interest rates, increasing profits. That, it seems, was fine in theory, but since the Fed confirmed its intention to start raising rates earlier this year, traders have seen things differently. Here is the chart of the financial sector ETF, XLF, from March 16, the day Fed Chairman Jay Powell announced the first rate hike in this series, through Friday’s close:

As you can see, despite this theoretical advantage for banks in a rising rate environment and after climbing for a few weeks on the news, XLF quickly turned the corner and lost 17.7% from its ending high. March. For comparison, the Dow Jones Industrial Average has lost about 12% over the same period. If you extend the chart further back in time, you will see that XLF is trading at the same level as February 2021, around the time the preparation for rate hikes began. He gave up all winnings from being the “obvious” rising rate game.

So, is rising rates really good for banks or not?

Well, yes, rising rates are good for banks in some ways, but there are concerns that the impact they will have on the broader economy will negate that benefit. You would think that inflation would encourage borrowing as household and business budgets tighten, but consumers and businesses are used to borrowing at low rates. If the increases scare them off and drastically reduce borrowing, the increased margin available to banks won’t matter. In addition, there are fears that the Fed’s response to inflation could push the economy into a recession, further reduce borrowing appetite and increase default rates on existing loans.

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

When you consider all the potential downsides of the current environment for financial stocks in this way, the lower XLF makes a little more sense. The fact is, however, that in the scary atmosphere created by a volatile market, these negatives are the only things traders and investors have looked at. They completely ignored the very real benefit of higher rates for banks.

This still exists, as a presentation from JP Morgan (JPM) on their Investor Day clearly shows. In it, the company said it now expects to achieve a return on equity of 17% by the end of this year, after dropping that target in January. The reason for their return to optimism? Rising prices.

All things considered, it looks like the market is doing what markets do, overreacting on the upside and then overreacting on the downside. While the market was still feeling bullish and traders focused on finding a sector that could benefit from rate hikes, financials soared; once the mood changed and the focus shifted with it, they crumbled and lost all those gains. However, as JP Morgan’s presentation makes clear, there are very real benefits to raising rates for banks. Equity prices in the sector at levels prior to these rate hikes therefore make no sense.

Based on this, 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 decline are looking 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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