Banks Could Be First Rate Casualty

Merrill Lynch cut its ratings on several financial stocks Thursday, saying a sharp jump in long-term interest rates makes them look fully valued.

Financial sector stocks weren't responding: The American Stock Exchange Broker/Dealer Index was up almost 1%, while the Philadelphia Stock Exchange/KBW Index was flat.

Merrill dropped its intermediate-term ratings to sell from neutral on a handful of asset managers, brokerages and market makers, including Huntington(HBAN Quote), Instinet(INET Quote), Charles Schwab(SCH Quote) and T. Rowe Price(TROW Quote).

The firm also cut its intermediate-term ratings to neutral from buy on Franklin Resources(BEN Quote), Fifth Third(FITB Quote), Legg Mason(LM Quote) and TCF Financial(TCB Quote).

It left its long-term ratings unchanged, including strong buys on Franklin, Legg Mason and TCF Financial.

Financials and long-term interest rates often rise in anticipation of economic recovery, but some financial stocks may have reached the end of their rally, Merrill's note suggests. The American Stock Exchange Broker/Dealer Index has soared 54% since Sept. 20, exceeding the Nasdaq's 29% jump since that date and the S&P 500's 19% rise. The Philadelphia Stock Exchange/KBW Index is up 24% since Sept. 20.

"The significant rise in [long-term] Treasury yields has caused financial stocks broadly to look fully valued," the note says. Yields on the 30-year Treasury bond have spiked up to 5.76% from 4.79% in November of last year.

Rising long-term interest rates can make returns on debt look more attractive than returns on equity investments, especially if companies aren't earning enough with respect to their share prices. The theory is widely followed among investors in financial stocks, which are generally viewed as interest plays and often move inversely to the direction of rates.

While economic recovery should lead to stronger revenue and earnings for financial outfits down the line, many are still suffering from weak profits now, depressing their earnings yield, or return on investment. Rising long-term interest rates also can eat into spreads at financial outlets that focus on lending.

"At present, only nine stocks out of the nearly 60 that we cover offer an absolute [return on investment] potential over 15%," Merrill wrote in the note.