Why Are Bank Shares Trending Lower Despite The Fed’s Latest Rate Hike?

by Trefis Team
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The Federal Reserve announced its decision to raise interest rates by 25 basis points (0.25% points) earlier this week – a move that was largely expected given strong economic growth and low unemployment rates, as inflation hovers around 2%. However, bank shares saw a notable decline in their prices immediately after the announcement, with the KBW Nasdaq Bank Index ending the day 1.5% lower. This trend appears to run counter to the fact that higher interest rates should translate to an increase in net interest margin (NIM) for U.S. banks – boosting their profits.

While the rate hike is definitely good news for the U.S. banking industry, the real reason behind the bank sell-off was the cautious forecast for interest rates as well as unemployment rates by the Fed for the newly added 2021 period. Comparing the Fed’s latest long-term projections with those after the June rate hike shows that the Fed foresees a reduction in these key metrics in 2021 after steady gains in 2019 and 2020. Although the Fed hasn’t changed its long-term forecast for these metrics (which have been well below the projections for 2020 for several quarters now), the move was seen by investors as a sign of caution about growth prospects for the U.S. economy over coming years.

This conclusion, in turn, led share prices lower across sectors. But bank stocks were hit in particular by the fact that an impending slowdown could lead to a flatter yield curve, and could also result in the yield curve inverting in the near future. This is bad news for banks as increasing short-term rates and declining long-term rates have a negative impact on the net interest margin figure and eat into bank profits.

We capture the trends in net interest margin for each of the five largest commercial banks in the country – JPMorgan ChaseBank of AmericaWells FargoCitigroupU.S. Bancorp – through interactive dashboards, while also detailing the impact of changes in the metric on their share price.

Understanding Trends In NIM Figures, And Their Impact on Banks

The low interest rate environment that has been prevalent since the economic downturn of 2008 put considerable pressure on interest margins for all U.S. banks over 2012-2015. However, the NIM figure for the industry has been upbeat over the last couple of years, as the interest rate environment improved thanks to the Fed’s rate hike process. The average net interest margin figure for the U.S. banking industry in Q2 2018 was 3.30% – up from the record low of 2.95% in Q1 2015.

However, as seen in the table below, there was a notable decline in the NIM figure for some of the largest U.S. banks in the second quarter even though the figure increased at the industry level. This key metric for U.S. Bancorp, JPMorgan and Bank of America fell primarily due to the flattening yield curve for the quarter, which resulted in their net interest income increasing at a slower rate than their net interest expense for the period. While Wells Fargo’s NIM figure increased as a result of its ongoing efforts to slash its non-core deposit base following the Fed’s growth restriction order, Citigroup is less sensitive to the Fed rate due to its extensive overseas operation. As the flat yield curve did not persist for long, the smaller banks continued to report an improvement in the NIM figure.

The NIM figures for individual banks are taken from their respective earnings releases, while the figure for the industry is as compiled by the Federal Reserve Bank of St. Louis here. The average figure shown here is the weighted average figure obtained by weighing the net interest income figure for individual banks with their respective portfolios of interest-earning assets.

However, if economic growth slows down, then the yield curve could remain flat for a longer period of time and could also invert (with short-term interest rates being higher than long-term rates). As banks make money by borrowing cash at short-term rates and then lending them out at long-term rates, a flattening or inverted yield curve would imply that they spend more money funding the loans – effectively making less money in the process.

The chart below helps understand how sensitive the banks’ results are to their NIM figure, as a reduction in Bank of America’s NIM by just 5 basis points (0.05% points) results in a reduction in its interest income by $1 billion (a decline of 2%). As there are negligible costs associated with the net interest income, a lower NIM figure also hurts a bank’s profit margin considerably – magnifying the impact on the bottom line.

Details about how changes to key traditional banking parameters (like NIM) affect the share price of the five largest U.S. commercial banks can be found in our interactive model for JPMorgan Chase | Bank of America | Wells Fargo | Citigroup | U.S. Bancorp

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