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Bank stocks rally hits concerns over short-term rates

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U.S. bank stocks have skyrocketed in recent months amid expectations that earnings will rise alongside longer-term interest rates that track 10-year Treasury yields. But some analysts believe that optimism may be overdone and that bank profitability remains under pressure.

The bullish case for banks is that rising long-term rates, coupled with low short rates, create a steep yield curve, which means banks’ deposit costs are low and their yields on loans and securities are high, which implies large profit margins.

But banking products like commercial loans are more closely tied to short rates than to long rates, and the Federal Reserve has signaled its determination to keep those rates low. The challenge this poses is evident from Wall Street earnings estimates, which show big bank profits in 2022 have remained close to 2019 levels.

Marty Mosby, banking analyst at Vining Sparks, said he recommended clients who profited from the rally in bank stocks reduce their exposure ahead of the first quarter earnings reports next month.

“Banks typically have two-thirds of their balance sheets in assets that are five years old or less – people get excited when the 10-year bond goes up, but the share of the [rate] the curve that matters is not going anywhere, ”he said.

The chief financial officer of a major U.S. bank told the Financial Times that 60 to 75 percent of his bank’s net interest income was sensitive to the federal funds rate – the overnight lending rate targeted by the Fed – and the remainder at long-term rates. .

Commercial loan prices remain low because they are tied to short rates, and credit spreads remain tight. “The price of commercial loans at Libor or prime, and that’s where we haven’t seen a lot of progress,” said Jeff Harte of Piper Sandler.

Normally, higher long-term rates suggest that short-term rates will increase over time. But in this cycle, the Fed plans to anchor short rates even if inflation exceeds target. In addition, deposit costs are already close to zero for many banks, so the cost savings resulting from lower rates during the pandemic have been offset by the losses.

As a result, Chris Whalen of Whalen Global Advisors believes yields on bank assets are expected to fall by 5-10 basis points over the next year, a significant drop given those yields hover around 1%.

Nonetheless, investors treated the rise in 10-year Treasury yields as a signal to buy from the banks. Since the bottom of yields last August, the KBW Banking Index has risen by two-thirds, tripling the performance of the S&P 500.

The correlation between yields on 10-year Treasuries and bank stocks has been above 50% since August, meaning that about half of the rise in bank stocks can be explained by yields. The correlation with the shorter rates was weaker.

Eric Hagemann of Pzena Investment Management said banks have also recovered because they are trading at a steep discount to the market and are about to release the huge loan loss reserves they have. put aside during the Covid crisis. He thinks stocks could get higher valuations “when people realize how resilient banks have been.”

For several of the biggest banks – Bank of America, Citigroup, Wells Fargo, US Bancorp and M&T – analysts expect profits in 2022 to be flat or down from the year prior to Covid in 2019.

JPMorgan Chase is expected to grow its profits the most, with total growth of just 12% between 2019 and 2022. cut its outlook for interest income in February, citing declining card and mortgage balances. He said loan volumes are expected to “normalize” by the end of the year.

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