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
In addition to downgrading Citigroup to a "hold" from a "buy" rating, O'Connor lowered his price target for the shares to $56 from $61, "to reflect the larger [price-to-forward-earnings] discount for the market sensitive banks (of 15-20% vs. our target group multiple of 11.5x) given lingering regulatory/legal risks, potentially more volatile capital markets revenues from a change in Fed monetary policy, and potentially lower long term growth prospects."
Many analysts are still quite positive on Citigroup because of the shares' discounted valuations to book value and forward earnings compared to most other large-cap banks, and also because of the potential for significant reserve releases and deployment of excess capital as the firm's runoff subsidiary Citi Holdings continues to wind down.
Even O'Connor calls Citi "the most compelling long-term recovery play," however, he sees limited upside over the short term, not only because of changes in Federal Reserve policy, but because "regulatory and legal uncertainties remain headline risks."
A major headline risk for Citigroup and other bank holding companies with significant investment banking operations is next week's expected finalization of the Volcker Rule, which is meant to ban short-term "proprietary trading" by the largest deposit-taking U.S. banks. Many of the largest banks have already shut down their proprietary trading operations, however, the final language of the Volcker-based regulations could sufficiently curtail the banks' hedging and market-making capabilities that they might consider spinning off their investment banking operations. This would, no doubt, please many critics calling for a breaking up of the largest U.S. banks.
Morgan Stanley Downgrade
Morgan Stanley has been a runaway outperformer, with the shares rising 64% this year through Wednesday's close at $31.13. The shares trade for 1.2 times their reported Sept. 30 tangible book value of $26.96, and for 12.3 times the consensus 2014 EPS estimate of $2.53. The consensus 2015 EPS estimate is $2.97.
Please see TheStreet's earnings coverage for details on the boost to the company's wealth management revenue following its assumption of 100% ownership of its former retail brokerage joint venture with Citigroup.
In addition to downgrading Morgan Stanley to a "hold" rating, O'Connor lowered his price target for the shares to $30 from $31.00, for the same reason he cut his price target for Citi, which was to reflect the discounted P/E for market sensitive banks.
According to O'Connor, Morgan Stanley has already "delivered on a number of key strategic initiatives around the equities business, wealth mgmt, ibanking, expenses and capital," although trading revenue has been "disappointing."
"However, we believe much of the improvement in execution is being currently being priced into the stock and additional upside in the near term will be more macro driven," O'Connor wrote.
Looking beyond the short-term worries over Fed policy, Morgan Stanley's leading market share for global equity underwriting, as well as its increased wealth management revenue and strong level of capital, "suggest upside longer term if positive macro trends continue and
MS continues to improve its execution," the analyst added.
Shares of Citigroup were down nearly 1% in the first few minutes of trading to $51.55, while Morgan Stanley was down 1.2% to $30.75.
The following chart shows the year-to-date stock performance for Citigroup and Morgan Stanley, as well as the KBW Bank Index and the S&P 500:
data by YCharts
-- Written by Philip van Doorn in Jupiter, Fla.
>Contact by Email.Follow @PhilipvanDoorn