NEW YORK (TheStreet) -- Citigroup (C) and Morgan Stanley (MS) were both downgraded on Wednesday to "hold" ratings from "buy" ratings by Deutcsche Bank analyst Matt O'Connor, in part because of the expected near-term curtailment of Federal Reserve bond purchases "seems more likely to be negative for banks/credit markets near term."
The Federal Reserve's "QE3" purchases of long-term U.S. Treasury bonds and agency mortgage-backed securities have been running at a net pace of $85 billion a month since September 2012. Most economists were surprised when the Federal Open Market Committee decided not to begin "tapering" the bond purchases following its September policy meeting. Since then, the partial shutdown of the federal government during the first half of October and a rise in the U.S. unemployment rate to 7.3% in October from 7.2% in September have been among several economic developments keeping the FOMC from making a policy change.
The FOMC next meets on Dec. 17-18. Expectations for a tapering of bond purchases following that meeting are at a much lower level than they were in September. However, there appears to be a consensus that the tapering will begin by the time the FOMC meets in March of next year.
The continued media focus on QE3 overlooks the Fed's main policy tool, the short-term federal funds rate, which has been in a target range of zero to 0.25% since late 2008. Most banks would love to see a parallel rise in interest rates, which would boost net interest margins, but O'Connor in a note to clients on Wednesday wrote that his firm's "bias is that short-term rates won't rise as soon as some expect -- possibly until following the 2016 US elections."
The half decade of near-zero short-term interest rates has distorted the market, with deposit savings rates near zero, while the nation's largest banks have seen very strong deposit growth. Meanwhile, most of the largest banks have seen their loan portfolios decline. According to the minutes from the Oct. 29-30 FOMC policy meeting, the Fed is considering cutting the rate it pays to banks who deposit reserves at the central bank from the current rate of 0.25%. Several of the largest banks would consider charging some customers to take deposits if that were to happen, since they just don't need the money.
Turning back to the QE3 tapering, O'Connor wrote that despite his firm's negative view of the coming reduction in central bank bond purchases, the near-term effect on markets and bank stocks "is hard to predict and will likely be very dependent on macro data and the outlook for corporate earnings."
The analyst also pointed out that the market had already made a significant adjustment with the rise in long-term interest rates in May and June, in anticipation of tapering.
Citigroup's shares closed at $52.04 Wednesday. The shares have returned 32% this year, slightly ahead of a 31% return for the KBW Banking Index (I:BKX) and also ahead of a 26% return for the S&P 500