The move in Treasurys has been greeted like an all-you-can eat buffet by bank investors starved for yield. But they might not want to gorge themselves all at once.
As the 10-year Treasury yield has jumped so far this year from around 0.9% to about 1.4%, U.S. big-bank stocks have risen over 20%. Meanwhile, the S&P 500 is up 4.5%. Banks’ move is justified in many respects, as higher long-term rates are fundamentally good for their lending business. And it is easy to see more room to run, as banks are still lagging behind the market overall since the pandemic began last year, and are historically still somewhat cheap relative to the S&P 500 on a price-to-earnings basis: about 34% cheaper, versus about 30% from 2014 to 2019.
But a closer look at how exactly banks might benefit from higher rates may put a damper on any emerging euphoria. What is unique about banks right now is that they are sitting on a mountain of unusually cheap deposits from consumers and businesses with a glut of savings. That has resulted in a big pile of cash sitting at the Federal Reserve earning nothing, which can in theory be rotated into securities. This is a very profitable potential trade: Analysts at Autonomous Research figure that big banks rotating just their present excess cash at the Fed into securities in 2021 and adding 1 percentage point of yield would increase the next year’s net interest income by 2.5% on average and earnings per share by roughly 5%.
But while banks’ actions in past cycles have sometimes been accelerants to rising rates, now they may be something of a curb.
For example, in the past banks have sometimes been sellers of mortgage-backed securities as rates across the board rise because the slower rate of repayment extends the duration of those bonds—a kind of risk banks don’t typically want. They worry about matching the duration of those assets to deposits, which could mean having to raise deposit rates.
This time around, banks are already swimming in deposits. So not only is there less pressure to sell mortgage bonds, they may even be likelier to be buyers. Though mortgage rates have risen in recent weeks, the move started later and has lagged behind that of Treasurys.
It might be a totally different story if there were a lot of loan demand, giving banks a place they would much rather put their cash. Banks’ most profitable assets tend to be floating-rate loans, like credit cards and corporate loans. But demand for borrowing from America’s consumers and businesses remains tepid. For example, card issuers’ balances in January were about 85% of what they were in December 2019, according to analysts at Wolfe Research.
this week actually lowered its 2021 net interest income expectation slightly from when it last gave a forecast, which analysts widely attributed in part to card balances being paid down.
Investors also historically don’t assign as high a multiple to banks’ earnings generated when they are simply arbitraging interest rates rather than building up lasting client relationships with lending, notes Autonomous’s John McDonald. That might be one explanation if banks’ valuation discount lingers, even as they stand to pick up more interest income from securities.
So a big part of the outlook for banks’ core earnings comes back to the same thing as everything else: the virus and the economy. A rapid post-Covid-19 ascent with little credit fallout could mean more lending at higher rates. If that is indeed what markets are betting on, banks could really feast even as a lot of other sectors suffer from higher rates.
But as debate still rages on that central question, what is happening right now for bank stocks may be more like an appetizer.
Write to Telis Demos at telis.demos@wsj.com
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