2 Banks to Benefit the Most From a Steeper Yield Curve

NEW YORK ( TheStreet) -- Despite the best efforts of the Federal Reserve, long-term interest rates are rising, which can greatly benefit some banks over the short term.

But with short-term rates likely to stay put for quite some time, investors need to consider the balance-sheet structure of a bank before assuming a benefit to earnings from the current steepening of the yield curve.

The central bank has kept its target short-term federal funds rate in a range of zero to 0.25% since late 2008, and has also been doing what it can to hold short-term rates down. The Federal Open Market Committee continues to say that the federal funds rate is not likely to be raised until the U.S. unemployment rate drops below 6.5%. With the unemployment rate rising slightly January to 7.9%, it seems unlikely that the Fed will make a move on short-term rates this year. Meanwhile, the Fed is continuing to expand its balance sheet in order to hold long-term rates low.

But investors have been anticipating the Fed's eventual reversal of course, pushing the market yield on 10-year U.S. Treasury bonds up by roughly 40 basis points to 2% over the past two months. Meanwhile, the market rate for 5-year Treasury paper has increased by 24 basis points to 0.84%.

"The fixed-income markets usually anticipate the eventual Fed moves and begin to adjust at least a year ahead of the initial Fed actions," according to Guggenheim Securities analyst Marty Mosby.

Most of the large regional banks have been seeing a steady narrowing of net interest margins (NIM) over the past two years, as their assets continue to reprice at lower interest rates. Despite the margin squeeze, a number of regional players have achieved sufficient loan growth to limit the decline of net interest income.

Mosby said in a report on Thursday that "the recent uptick in long-term interest rates has whetted the appetites of bank investors for the grand prize: rising interest rates." That would mean a traditional increase in all interest rates, following action by the Federal Reserve to raise the federal funds rate.

"The traditional rising-rate scenario is a parallel shift in all interest rates along the yield curve. This type of rate rise should benefit the most asset-sensitive banks that are extremely mismatched," Mosby wrote. In a rising-rate scenario, the banks with loans and securities investments maturing or repricing faster than their deposits and borrowings, have the most to gain over the short term.

First Horizon National ( FHN), Regions Financial ( RF) and Zions Bancorporation ( ZION) "have more than 70% of their respective assets in the tactical pool (assets with maturities or repricing under one year), while less than 50% of their respective funding would be in the tactical pool," according to Mosby. "This leaves 20% of their balance sheets ready to reprice when short-term rates begin to rise, with no corresponding increase in funding costs tied to those assets."

These banks would see their net interest margins increase by roughly 40 basis points if the Federal Reserve were to raise the federal funds rate by 1 percentage point, according to Guggenheim's data. "However, we would not expect this impact until late 2014 or early 2015," Mosby wrote.

For some investors, that's a long time to wait. In the meantime, a steepening yield curve allows banks "that have more strategic assets than strategic funding sources to take advantage of those higher interest rates to help stabilize their net interest margins as we move further into 2013," according to Mosby.

Wells Fargo ( WFC) and State Street ( STT) "would benefit the most from a yield curve steepening," among the large-cap banks covered by Guggenheim. Mosby said that "these are the only two banks in our coverage that have more assets than funding sources in the strategic pool (assets and funding with maturities over three years)."

As part of his analysis, Mosby used Moody's forecasts that 5-year market rates would rise by about 70 basis points over the next six months, with 1-year rates rising by another 50 basis points. Moody's is also forecasting that "the 5-year and 10-year securities to be approximately 150 basis points and 110 basis points higher than their current levels, respectively."

Wells Fargo's fourth-quarter net interest margin was 3.56%, narrowing from 3.66% in the third quarter and 3.89% in the third quarter of 2011. The company's net interest income was $10.64 billion in the fourth quarter, declining from $10.66 billion the previous quarter and $10.89 billion a year earlier. If the Fed takes no action, while the yield curve steepens by 1 percentage point, Mosby estimates that Wells Fargo's net interest margin will widen by 20 basis points to 3.66%.

State Street's fourth-quarter net interest margin was 1.36%, contracting from 1.44% the previous quarter and 1.4% a year earlier. The company reported tax-adjusted fourth-quarter net interest revenue -- excluding "conduit-related discount accretion" -- of $600 million, declining from $611 million in the third quarter, but increasing from $577 million year earlier. Mosby estimates that if the yield curve were to steepen by 1 percentage point, State Street's net interest margin would expand by 36 basis points to 1.66%.

Mosby rates Wells Fargo a "buy," with a price target of $46.50, and estimates the company will earn $3.90 a share this year, with EPS increasing to $4.30 in 2014.

The analyst has a "neutral" rating on State Street, with a $57 price target, and estimates the company will earn $4.50 a share this year and $5 a share in 2014.

-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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