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Interest Rate Rise Complicates Banking Recovery

The reality is that as interest rates rise from generational lows over the next few quarters, many large banks may struggle to maintain their recent strength.

A recent bubbling of investor confidence in large banks may wind up disappointing investors, in the short run.

The good news, however, is that rising interest rates are likely to be beneficial to the earnings of most banks over the long term. The industry also appears far better equipped to handle writedowns than at any previous point in recent memory.

Bill Smead, chief investment officer for mutual fund Smead Capital says lenders like Wells Fargo will see larger gains from loan portfolios than losses from securities books.

Smead, who began building stakes in large banks like Wells Fargo in 2009, takes a long view on investors' current daily obsession with interest rate moves. He expects the current rise in interest rates will allow banks to begin investing their excess capital in new loans instead of debt securities. Such a scenario would mark a strengthening earnings cycle for the banking sector.

In fact, as the yield curve steepens, Smead is more concerned with an eventual flattening years down the line. "Banks have been disappointing investments as you move from a steep yield curve to an inverted yield curve," he said.

The current rise in interest rates may expose overly-optimistic near-term valuations across the banking sector. A minimal long-term impact of bond portfolio writedowns could also strengthen arguments that the industry is far healthier than it was last time the Fed began to raise interest rates.

-- Written by Antoine Gara in New York

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