A headline news flash will almost always associate with rising interest rate with tailwind to bank stocks. But what is often missed is that banks’ profitability is associated with net interest margin: the yield they make lending long term subtract the short-term interest they are paying to their lenders (Fed or deposits etc.).
In other words, Federal Reserve kept on rising short term rates are not necessarily a tail wind to bank stocks (In a weird way, it is actually a head-wind since the banks are paying higher short-term interests right after rate hike). What matters more is yield curve.
What is a yield curve?
A yield curve is just a plotting of near-term rates, intermediate rates and long-term rates onto a chart. Normally there will be a positive term premium: 10-year yield should be higher than a 2-year yield. However, there are certain situations when the curve is “inverted”: 10-year yield was lower than 2-year yield, that’s the term structure will give a lot of concerns in the financial markets. It tells you something: People are willing to buy lots of 10-year treasury than they are inclined to buy 2-year treasuries.
What is the message an inverted yield curve trying to convey?
- The market believes that longer-term real rate and inflation are going to be lower than near-term’s real rates and inflation.
- The players in the market are trying to lock-in a stable long-term fixed income return rather than facing re-investment risks every now and then. They are less confident to find good investment opportunities in today’s market so they would like to allocate resources to lock-in a stable long-term fixed return
- Some players are betting Fed may have to cut short-term rates over the next few years so the short-term rates, although higher than 10-year treasury, could be temporarily high for now
When did it happen last time? 2006, right before the financial market blew up
What an inverted yield curve means to bank stocks?
Disastrous. As we mentioned before, the banks’ main business model is to lend long and borrow short, making the spread in between. Now if the 10-year yield is lower than, say, 3-month treasury, the bank may only be able to break-even with the credit spread they assess on their lending. The net result is that they are running a razor-thin net interest margin, which will significantly impact their profitability.
Lots of portfolio managers were rushed to add banks stocks into their portfolio on the basis of rising rates environment would provide a healthy tail wind to banks. However, this is only part of the story. If the rates are rising on both short-end and long-end, and with long-end rising faster than short-end (yield curve steepening), bank stocks will bring great profitability to the portfolio. On the other hand, if the yield curve started to invert, or even just flattening, with the level of leverage embedded in banks (by design and definition), those stocks are not guaranteed to benefit in a rising rates (short-term rates) environment at all.