Bank Stocks Are No Haven From Rising Rates

Rising rates have been good for bank stocks in the past. That time appears to be over—for now. If casual investors know anything about bank stocks, it may be that they are a market sector that can benefit from higher interest rates.

But this conventional wisdom rests on some assumptions. For one, that banks’ interest earned on assets like loans will go up faster than the costs of their liabilities like deposits. Also, that rising rates can be a good sign for the economy and a signal of rising loan demand or relatively low credit risk.

But it looks like investors have lost faith in this historical relationship. Autonomous Research analysts measured the correlation between one-month changes in the KBW Nasdaq Bank index and 10-year Treasury note yields.

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The two have generally moved in the same direction every year since the aftermath of the 2008 global financial crisis—a period that included the rate-hiking cycle before the pandemic. Yet so far in 2022, the correlation has been negative. And it has been even more extreme in that direction since the 10-year yield hit 3% in May, Autonomous noted.

Correlation between one-month change in 10-year U.S treasury yields and KBW Nasdaq Bank Index

There are many reasons for this breakdown. Though banks have yet to run through the huge excess of deposits that came their way during the pandemic, and deposit rates have stayed relatively low, many signs point to rising pressure on funding costs.

The rapidity with which rate expectations have moved higher, driven by Federal Reserve Chairman Jerome Powell’s hawkish tone, has meant that even money market funds that invest in short-term instruments may have yet to fully catch up to rising rates. But money funds can do that soon: Barclays strategists expect yields to exceed 3% this fall.

Better rates on offer from money-market funds can push banks to move deposit rates higher to compete.

“We wonder if banks have become somewhat complacent,” Barclays strategists wrote in a note this week. For context, analysts at Wolfe Research expect interest-bearing deposit costs at the large consumer-facing banks they track to average about 1.6% in the third quarter.

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On top of that, there is increasing worry about credit risk, or the possibility of losses on loans. In a recent survey of investor clients by Piper Sandler analysts, 55% of respondents said that credit risk was the biggest short-term risk to banks. In a survey last year, just 5% said that.

Higher rates present challenges through banks’ portfolios as well, though these look transitory. Mark-to-market losses on banks’ fixed-income investments have put some pressure on capital levels. That capital hit can reverse once those instruments mature, and banks will be able to reinvest at higher rates or do more share buybacks. The risk would be if banks had to start selling bonds at a loss because they needed cash to meet liquidity needs. But large U.S. banks’ cash piles remain sizable, at around 11% of total assets, up from closer to 8% prepandemic, according to Fed data.

Banks aren’t trading at challenging prices at the moment. S&P 500 banks sit at a slight discount to book value, and under 10 times analysts’ consensus 2022 earnings estimate, according to FactSet. Both are discounts to banks’ 10-year averages, and represent a steeper discount than usual to broad-market S&P 500 multiples.

So investors can no longer count on bank stocks as a counterweight to rising rates. But banks shouldn’t be totally left on the side of the road, either. An investor with a longer time horizon might view the biggest banks, with deposit franchises most insulated from competitive pressures, as a way to bet on a soft landing for the economy.