Bank stocks beat the S&P 500 Monday and have been doing as much in the past five trading days, when market sentiment seemed to turn. The one consistency accompanying the strong performance: a rise in interest rates.
Since March 23, the S&P 500’s coronavirus-induced bear market low, the index has risen about 32%. Banks stocks have lagged, with Invesco’s KBW ETF (KBWB) - Get Invesco KBW Bank ETF Report up just 23%.
The Federal Reserve has given the banking system and economy a shot in the arm with liquidity, supporting short-term funding markets, which brings the federal funds rate down and injects cash into the system for lending. On the risky end, the Fed has bought longer-dated and credit-dependent corporate and mortgage bonds. Lower interest rates mean more lending but also potentially compressed net interest margins, or the percent of interest income a bank keeps after paying interest to its own lenders and depositors.
“It’s clear that the biggest headwind for banks is persistently low levels of rates, particularly at the back end of the curve,” wrote Morgan Stanley’s Chief U.S. Equity Strategist Mike Wilson in a note. “In our view, this is the main factor holding back the absolute and relative performance of the banks.”
After having taken a short breather, the S&P 500 has gained 4.8% since May 13. And Monday, it gained as much as 3.3%, as Federal Reserve Chairman Jerome Powell said the economic recovery may very well be fast and that GDP may grow at a positive rate in the third quarter, rather than contracting a slower rate as some strategists expect.
But in that time, the KBW is up 9% and up 6% Monday. The KBWB’s large cap components, JPMorgan (JPM) - Get JP Morgan Chase & Co. Report, Citigroup (C) - Get Citigroup Inc. Report, Wells Fargo (WFC) - Get Wells Fargo & Company Report and a few others, comprise about 30% of the fund, leaving 70% of the fund weighted towards regional and more yield curve sensitive banks. This makes it a solid gage on the way the market views traditional banking.
Since May 13, not only has the 10-year treasury yield risen to 0.73% from 0.63%, but with the 2-year treasury yield moving more marginally to 0.19%, the spread is now 54 basis points, which is confirmed by the very exacting data from the St. Louis Fed. The spread was just 48 basis points May 13.
But before the late March rally got underway, investors had several days of selling any asset that wasn’t exactly like cash, sending treasury yields higher and the 10 to 2 year spread to 68 basis points. And throughout April, a huge month for stocks, the spread struggled to get above 44 basis points.
Another potential drag on bank earnings estimates is credit losses, which banks have to absorb through loan loss provision expense in the near-term and the failure to collect in the longer-term.
Also helping bank stocks since late last week: evidence that lower rates are indeed spurring high loan volumes. Companies issued $730 billion in investment grade bonds last week. That compares to $975 billion in al of 2019 in the U.S. And bank stocks continued rallying hard last week, although some market participants aren’t so quick to be bullish. The rush for capital may very well be a reflection that companies are uncertain about the future and want to shore up liquidity at low rates now, Michael Sheldon, Chief Investment Officer of RDM Financial Group told TheStreet.
Longer-term, Wilson points out the fed funds futures market, which reflects expectations of short-term interest rates, forecasts zero rate hikes in the next three years.
Sure, banks are trading at attractive valuations compared to their histories. JPMorgan, which usually commands a premium valuation to peers, currently trades at roughly its book value, while Bank of America and Wells Fargo trade at below book value.
But while Wilson expects V-shaped recovery that may precede an environment conducive to a steeper yield curve, Wall Street’s consensus is that the economy can only stay on track post-COVID 19 if rates remain low, which makes it hard for the yield curve to expand.
Bank investors should also consider business conditions in investment banking, capital markets and other services.