Higher Rates Aren't So Bad for Banks, After All

It's an old saw -- higher interest rates are bad for banks. So every time interest rates tumbled this year, as they did throughout August, bank stocks rallied.

But the conventional playbook about rates and financial stocks may not be accurate in the current environment, which should prompt a re-evaluation of the sector's recent strength, and what it says about the outlook for the economy and Federal Reserve policy.

Financial stocks are "not very well understood," (RPFGX Quote)Davis Financial fund co-managers Christopher Davis and Kenneth Feinberg wrote in their summer commentary. "Rising interest rates do not inherently threaten profitability at all financial service companies."

Among the fund's top holdings at the end of June was Golden West Financial (GDW Quote), which makes almost all of its loans adjustable rate. The savings and loans business "will thrive during the current period of rising rates," Davis and Feinberg wrote.

And thanks to the glaring, can't-miss warnings from the Fed that rate hikes were on the way, many more traditional financial institutions have been turning their balance sheets upside down to get ready for higher rates.

For example, Wachovia (WB Quote), Bank America (BAC Quote) and Bank of New York (BK Quote) all said last month in respective regulatory filings, that their incomes would likely be higher if rates rose -- and lower if rates fell.

Investors haven't gotten the message and still fear higher rates. As a result, by historical measures, banks as a group are at the low-end of their valuation over the past 10 years. Overall, the price-to-earnings multiple of the biggest banks has dropped below 15, according to Lehman Brothers.

That's only the third time the ratio has been below 15 since 1996, according to Lehman. Until a slight move up last month, it was also the first time since that year that the 12-month forward P/E ratios of Citigroup (C Quote), J.P. Morgan (JPM Quote), Bank of America and Wachovia were all below 11 at the same time.

How the PHLX Bank Index Has Done Vs. the 10-Year Treasury Note

Source: Yahoo Financial and the Philadelphia Stock Exchange