After an impressive surge in bank stocks on Tuesday due to lower-than-expected inflation data driving bond yields down, there is growing optimism on Wall Street that a more sustainable recovery is on the horizon.
Initially, higher bond yields are beneficial to banks as it allows them to earn greater interest on their assets. However, when interest rates rise too rapidly – as witnessed during the recent tightening cycle by the Federal Reserve – bank stocks tend to suffer.
Currently, banks are grappling with rising funding costs and a decrease in the value of bonds on their balance sheets. The pressure is intensified as higher interest rates lead to banks being more cautious in extending new credit. They worry about potential loan delinquencies.
Nevertheless, if the decline in bond yields continues, it could spell a reversal of these challenges for bank stocks, offering ample room for price increases. This is undoubtedly necessary given that, despite some recent gains, the SPDR S&P Bank ETF (ticker: KBE) has declined by approximately 12% thus far this year, while the S&P 500 has seen a rise of 17%.
With each increase in interest rates, bond prices decline. Consequently, the Fed’s rate hikes have resulted in banks experiencing hundreds of billions of dollars in unrealized losses on their bond portfolios. However, lower bond yields have the potential to expedite a rebound in fair value, allowing these losses to be mitigated. This positive development was highlighted by Jeff Rulis, a senior research analyst at D.A. Davidson, on Wednesday.
The timing of such a rebound would be excellent as it would alleviate one of the primary headaches banks currently face. Not only would the losses themselves be reduced, but banks would be required to hold less capital against their bondholdings.
It is worth noting that banks are compelled to hold additional capital against assets that are deemed riskier. This includes certain bonds and loans, which ultimately impairs their profitability.
The Changing Landscape of Banks and Consumer Debt
The recent challenges faced by banks extend beyond economic uncertainty and market volatility. Concerns have arisen regarding the ability of consumers to repay their debts, though delinquency rates remain relatively low. As a result, banks are now required to maintain higher levels of capital to meet regulatory standards.
According to industry expert Rulis, a potential reversal of unrealized losses in bond portfolios could provide a buffer against increased credit costs. This is particularly beneficial for banks with Tier 1 capital ratios below 7%, including Comerica (CMA), KeyCorp (KEY), Zions Bancorporation (ZION), and Fifth Third Bank (FITB), among others.
In addition, a decline in bond yields can have positive implications for banks in multiple ways. Interest rates for borrowers are closely tied to Treasury rates. High interest rates have deterred individuals from seeking new mortgages and businesses from taking on debt for new ventures. However, as yields decrease, reluctant borrowers may be more inclined to enter the market.
The notion that lower rates can benefit banks is supported by historical evidence. In 1995, after the Federal Reserve implemented two interest rate cuts, bank stocks saw an average increase of 54%. This signified to investors that the period of monetary tightening between January 1994 and February 1995 had come to an end, as stated by Gerard Cassidy, an analyst at RBC Capital Markets.
Furthermore, with current bank stock prices still below historic valuations, Cassidy expresses optimism for the sector’s growth potential. He argues that if the Fed were to reach its terminal rate in the near future, bank stock prices would surge and investors would reap the rewards.
This positive outlook couldn’t have come at a better time for bank investors, who have eagerly awaited news that could revitalize the sector.