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Robust Economy and Rising Yields a Boon for Banks
The reasons for this big win are the news of a more robust economy and higher bond yields.
Early in the week, the U.S. government reported solid sales for existing and new homes, followed by a strong GDP report and lower initial jobless claims later. This news helped pushed bond prices lower and bond yields higher, as a more robust economy usually leads to higher inflation, which reduces the supply of “loanable funds.”
The benchmark 10-year Treasury bond yield rose from 1.25% early on Monday to 1.36% by Thursday and closed at 1.31% on Friday. That’s well above around 0.65% it was in the summer of 2020.
A more robust economy and higher bond yields help banks’ top and bottom lines in two ways. First, a strong economy raises the demand for bank loans. Second, it boosts the interest rate spread. That’s the difference between the short-term interest rate banks pay customers for deposits, and the long-term interest banks collect from loans and investments in bonds.
The interest rate spread is often referred to just as “spread” in the Wall Street jargon. It is the critical metric of a bank’s gross profit margin. When long-term interest rates drop faster than short-term interest rates, the interest rate spread narrows, reducing profitability, as was the case during the COVID-19 recession. Conversely, when long-term interest rates rise faster than short-term rates, the interest rate spread widens, raising banking profitability, as has been the case in recent months, with the American economy recovering.
Simply put, banks have two tailwinds behind them: a more robust economy and rising yields that help boost their top and bottom lines.
Fed’s” Middle Road” is Good for Banks
The Federal Reserve has chosen a “middle road” with monetary policy going forward, tapering its bond-buying program while keeping short-term interest rates steady at near-zero levels (see: “The Fed Chair Takes the Middle Road”). That very likely means a more robust economy and a higher spread, adding fuel to the rally in bank and financial shares.
TipRanks gives large banks high Smart Scores, citing strong technicals and fundamentals. For instance, Bank of America and Wells Fargo both receive a Smart Score of 9, while JPMorgan receives a Smart Score of 8, and Citigroup receives a Smart Score of 10.
Meanwhile, the analyst community rates Bank of America, Wells Fargo, and JPMorgan as Moderate Buys, while it rates Citigroup a Strong Buy. Apparently, there’s some concern about valuation after financial stocks had a big run-up since the recovery from the COVID-19 recession began. Analysts are also concerned about insider selling, and the rise of peer-to-peer lending that could undermine conventional financial intermediation.
Summary and Conclusions
A more robust economy and rising bond yields have been solid tailwinds for financial stocks that recently outperformed the S&P 500. That’s a situation expected to continue in the near future as the Fed’s middle road monetary policy could keep the economy growing and bond yields rising for quite some time.
Disclosure: At the time of publication, Panos Mourdoukoutas did not have a position in any of the securities mentioned in this article.
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