Why the Bank Rally Is Over

For bank stocks, factors from interest rates to loan growth are all looking worse

By Aaron Back
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The big problem for banks right now is that short-term rates, which are largely controlled by the Fed, aren’t likely to go higher for a while. A customer enters a Citibank branch in New York. Photo: Mark Lennihan/Associated Press        


Bank stocks are having a hard time making the transition to autumn. The forecast is for chilly conditions to continue.

Following strong gains for most of the summer, the KBW Nasdaq Bank Index has fallen around 6% over the past month compared with a decline of less than 1% in the S&P 500. The immediate trigger appears to be a sharp move downward in long-term interest rates. This certainly isn’t helpful to banks, but their biggest problems at the moment actually lie elsewhere.

The yield on 10-year U.S. Treasurys has fallen to 2.07% from 2.22% over the same period. One reason is that North Korean weapons tests have goosed demand for safe-haven government bonds. Other factors driving the downshift in rates include weakening employment growth, which has weighed on economic confidence.


NOT BANKING ON HIGHER RATES
Probability implied by futures markets of 25 basis-point increase in December



There is a case to be made, though, that investors in bank stocks focus too much on the 10-year rate. After all, commercial banks don’t typically hold many 10-year assets. In the second quarter, just 28% of total bank assets had terms of more than five years, according to data from the Federal Deposit Insurance Corp.

In a note on Wednesday, analysts at Goldman Sachs argued for a bet on bank shares. They pointed out that 54% of loans at the biggest lenders have floating rates, meaning they adjust automatically in line with short-term benchmarks such as the Libor or prime rates.

As a result, movements in short-term rates matter more for most banks’ profitability than movements in long-term rates. This explains why banks’ net interest margins have steadily expanded this year despite a flattening yield curve.

The big problem for banks right now is that short-term rates, which are largely controlled by the Federal Reserve, aren’t likely to go higher for a while. Markets are now pricing in a 36% chance that the Fed will raise rates at its December meeting, according to the CME Group , down from more than 50% in early July. Stubbornly low inflation, lukewarm employment reports and the uncertain fallout from one or possibly even two disastrous hurricanes have tempered rate bets.

Various other indicators also are pointing in the wrong direction for banks. Loan growth continues to be slow, capital markets activity is weak, and defaults on consumer loans are ticking up. The glorious bank rally following last year’s presidential election suddenly seems like a long time ago.

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