When Will Bank Stocks Benefit from Interest Rate Hikes?

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The era of quantitative easing may be on its last legs. The Federal Reserve Bank, the Bank of England, the Bank of Canada, and perhaps even the European Central Bank will soon be on the same page. The 2008 global crisis dramatically changed the financial landscape as central banks slashed interest rates and pumped billions upon billions of dollars into the global economy. This monetary policy approach was known as QE a.k.a. quantitative easing. The Bank of Canada has raised interest rates twice in 2017, and the Bank of England has raised interest rates once this year. These trends are likely to continue into 2018 and 2019.

There are two ways that central banks can expand economic stimulus: purchasing assets i.e. pumping money into the economy, and cutting interest rates. The Fed adopted an aggressive multi-pronged strategy encompassing both approaches. The result was historically low interest rates for several years until the US economy got back on track. In the interim, banks took a massive hit. The likes of Wells Fargo & Company, Goldman Sachs, Bank of America, JPMorgan, Citibank, Deutsche Bank, UBS and others were heavily impacted by the sudden demise of high interest rates.

Interest-Related Revenue Streams Set to Rise

Banks rely on interest-related revenue streams to generate their profitability. This comes in the form of credit cards issued by banks, personal loans, business loans, and other credit financing. The interest rates that banks pay their savers are always lower than the interest rates banks charge their borrowers. That’s how banks make their money – on the spread. When the overall interest rate is low (as it was prior to December 2015 in the US), banks tend to generate less profits. Since there is fierce competition for customers in low interest-rate economies, there are typically many enticements to lure people in through the door.

First of all, mortgages are especially cheap, as this encourages bank lending to qualified buyers. Buyers benefit knowing that the interest-related payments on 15 year, or 30 year mortgages are sufficiently low to justify the purchase of a property. Bank profits were whittled away in the wake of the global crisis, owing to the pummelling that banks were subject to by the authorities. But then came December 2015, and the first interest rate hike in many years for the US.

The Fed Has Hiked Interest Rates Multiple Times in the Last Two Years

Since the US economy started improving, the Fed eased up on its quantitative easing in favour of quantitative tightening. This takes the form of higher interest rates. Not wanting to rock the US economy too much, the Fed opted for a series of gradual rate hikes in 25-basis point increments. Wilkins Finance strategist, Martin Lowry explains how the Fed impacts demand for bank stocks,

‘… The US economy has been prospering for quite some time. We have a historically low unemployment rate, terrific business and consumer confidence, and a stock market that has hit the stratosphere. The election of Donald Trump to the White House was largely viewed as a positive development for the economics of the region, and so far, so good. Despite protestations to the contrary, Trump has proven to be a boon and not a bane. Politics aside, the current interest rate in the US is 1.00% – 1.25%. For every 25-basis point rate hike, stock markets get a little jolt. We can expect interest in bank stocks to start rising, given that banks profit directly from interest rate increases. Think of the credit card companies like American Express, Visa, MasterCard and the like – their profits are directly linked to the interest rate. While Wells Fargo & Company has floundered in recent months, Bank of America has prospered. There are peripheral issues that need to be considered, such as the massive data breach scandal at Wells Fargo which did not help their share price.’

Investors realize that the long-term benefits of interest rate hikes on bank stocks will be positive. Provided banks manage their affairs cautiously and judiciously, there is no reason why bank stocks such as BAC, or WFC will not appreciate sharply moving forward.