Rising Rates Will Not Help US Banks

Summary

• More people are suggesting investors position for tighter Fed policy by overweighting US banks and financials.
• Analysing the past two tightening cycles suggests banks and financials will struggle to outperform the broader market. Where they did, it was not due to rates.

Market Implication

• We do not expect US banks and financials to outperform the S&P 500 in the foreseeable future, although more technical bounces are possible.
• We prefer to be market-weight bank and financial services. This can be done via three ETFs: KBWB, KRE, XLF.

With the Fed poised to start raising rates in coming months, some suggest bank equities should benefit in this environment. The rationale is that interest income on loans should rise faster than the cost of bank liabilities – primarily deposits. Also, a potentially steeper yield curve should add to net interest margins.

These are not new arguments – they tend to surface every time the Fed starts raising rates. We are sceptical of them but will return to that later. Let us first focus on facts.

Financials Did Well – But Not Well Enough

At this point, we have financial equity indices going back to the early 2000s. How did they perform during the Fed tightening cycles beginning in mid 2004 and late 2015?

For this exercise, we focus on the S&P 500, major banks, regional banks, and the broad financial sector, including banks, insurance companies, and other financial services providers such as Mastercard and American Express (Table 1).

The performance is encouraging. Between mid 2004 and late 2006, banks and financial services rallied by 42%. Then, between late 2015 and mid 2019, banks rose 45% and broad financial services 49% (Chart 1).^[1]

But the key question is, how did they compare to the broader S&P 500? Chart 2 reveals this, and the answer is more ambiguous at best.

During the 2004-2006 tightening cycle, bank equities essentially performed in line with the S&P 500. The broader financial services index jumped about 12% in 2005, then trended down. That strong performance reflected two events. First was strong equity performance by non-bank financial services during the go-go housing boom years, such as Goldman Sachs (+64%), American Express (+18%), and Morgan Stanley (+23%). A second factor may have been the downgrading of Ford and General Motors to junk in June 2005. That substantially raised funding costs for their financial subsidiaries and allowed financial services competitors to enter their markets.

Default Cycle Drives Financials in 2016

About a year into the tightening cycle starting in December 2015, the regional bank index jumped by a third. And major banks and financial services rose 12% and 17%, respectively. This was largely due to an unwinding of a selloff a year earlier in response to the sharp decline in oil prices and rising defaults among shale oil drillers. Banks and financial services with energy industry exposure rallied as defaults were cresting and credit exposures became clear.

Is This Time Really Different?

This analysis strongly suggests that to the extent financials outperformed during the past two Fed tightening cycles, it was due to special factors unrelated to the Fed. During periods with no special event, banks and financials performed in line with or underperformed the S&P 500.

To overweight financials at this time, we must either know of some special factor that will benefit financials or believe things are different this time.

We see no special event that might drive banks and financials to strongly outperform in the foreseeable future.

As noted above, we are sceptical of arguments that financials should outperform as rates rise. First, of course, is the experience of the past 20 years during tightening cycles.

Second, it is unclear why rising rates help banks in some systemic way. Many loans and deposits are indexed to short-term rates. Both rise as the Fed tightens policy. There may be some benefit from lags, but it is not large, and it will unwind when rates fall in the future.

In every past tightening cycle, the yield curve has flattened as the Fed raises rates and even inverted near the end of a tightening cycle. This does not help net interest margins.

Admittedly, differences exist between most previous tightening cycles and now. With the Fed winding down its bond-buying program, inflation high, and 10-year real rates still near -1%, room arguably exists for longer-term rates to rise and outpace the Fed Funds rate. But with long-term inflation expectations around 2.5%, 10-year yields are unlikely to soar without a major shock.

Market-Weight Financials

At this point, we see no strong case to over- or under-weight banks and financials based on underlying fundamentals. We don’t rule out technical bounces as the Fed raise rates – if only because of a conventional wisdom that banks should benefit. But it is unlikely to persist. Trading oriented investors may want to position for this possibility.

Otherwise, we suggest investors market-weight banks and financials. They can do so via ETFs – KBWB for major banks, KRE for regional banks, and XLF for the broad financial sector.

[1] The strong post-2009 performance of the broad financials was because they sold off less than banks during the financial crisis. If performance is rebased to a year after the GFC, the profile is more in line with banks.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)