Banks Want Two Moves From Fed

NEW YORK (TheStreet) -- Regardless of what happens Wednesday, a tapering of Federal Reserve bond purchases is a near-term event. However, most banks are eager to see a change in Fed's main policy tool, the short-term federal funds rate.

U.S. stock futures were very strong before trading opened on Monday, indicating most investors were in line with most economists in believing the Federal Open Market Committee won't make any change in the Federal Reserve's "QE3" stimulus policy following the conclusion of the FOMC's two-day meeting on Wednesday.

In an effort to  hold down long-term interest rates, the Fed has been purchasing long-term U.S. Treasury and agency mortgage-backed securities at a net pace of $85 billion a month since September 2012.  The bond purchases had their desired effect, with the market yield on 10-Year U.S. Treasury bonds dropping below 1.70% in early May.

But the yield on the 10-year bond shot up to close to 3.00% leading into the FOMC's September policy meeting, after which the committee surprised investors by making no change in the Fed's bond-buying policy.

Some of this month's economic data has been very encouraging, including upward revision of the third-quarter gross domestic product growth estimate to an annual rate of 3.6% from the previous estimate of 2.8%, along with the decline in the unemployment rate to 7% in November from 7.3%.  But most economists don't think the data is enough for the Fed to taper bond purchases this week.

Sterne Agee chief economist Lindsey Piegza wrote in a client note on Friday that "one of the reasons that the FOMC has been able to extend the tapering timeline and err on the side on caution to ensure the labor market is strong enough to withstand weaker policy accommodation, is the fact that the Fed's second mandate, stable prices, is well under control."

As we saw in September, the FOMC is quite willing to go against the expectations of the market, so there's a possibility some investors will be in for a rude surprise on Wednesday.

But there's a strong consensus among economists that the Fed will announce at least a slow tapering of bond purchases after its March 2014 meeting, or even earlier.

The consequent rise in long-term rates will put additional pressure on mortgage lenders, which have already seen a significant drop in refinance applications this year.  Rising long-term rates will also help banks widen their net interest margins, but only slightly, as we have seen this year.

The Federal Funds Rate

Many investors and media outlets, in their relentless focus on "QE3 tapering," are neglecting the short-term federal funds rate, which has been locked in a target range of zero to 0.25% since late 2008.

The FOMC has said this "highly accomodative" policy is likely to remain appropriate until the U.S. unemployment rate drops below 6.5%, but Outgoing Federal Reserve Chairman Ben Bernanke has repeatedly said the federal funds rate could remain in its present range for an extended period even after that threshold has been met.

Most banks saw the bulk of the benefit from the historically low fed funds rate -- lower costs for deposits -- before 2013.  Meanwhile, the banks saw continued pressure on their net interest margins because assets -- loans and securities -- kept repricing at lower rates.

Long-term interest rates will increase significantly during 2014 as the Fed tapers.  But the great majority of the banks will see the greatest benefit when short-term rates rise.  Bank of America (BAC) in its third-quarter 10-Q filing said an instantaneous parallel rise in long-term and short-term interest rates would boost its annual net interest income by $3.438 billion.

JPMorgan Chase (JPM) in its third-quarter 10-Q said a parallel instantaneous rise in long-term and short-term interest rates of 100 basis points would boost its annual net interest income by $2.226 billion, based on its Sept. 30 balance sheet.  A parallel interest rate increase of 200 basis points would boost JPM's net interest income by $4.092 billion, according to the company.

Shares of Bank of America and JPMorgan were up in premarket trading Monday.  The following chart shows the year-to-date performance of both stocks, against the KBW Bank Index (I:BKX) and the S&P 500 :


BAC Chart
data by YCharts


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

>Contact by Email.

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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