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Stock Strategist

When Rising Rates Benefit Bank Stocks

Many banks stand to earn more money if the Fed takes action.

The Federal Reserve will likely soon start raising rates, so once again it must be time to dump your bank stocks. Or are you supposed to buy them just before rates rise? When it comes to interest rates, it's hard to keep the conventional wisdom straight.

The truth of the matter is that there's no simple rule to follow regarding bank stocks and interest rates. Banks don't live and die by where the Fed sets short-term interest rates. Rising rates can sometimes benefit these firms in the short term and other times can cause some of them to take an earnings hit. It all depends on how a particular bank has positioned its balance sheet and what the firm's mix of business consists of.

Prompting the groundswell of talk about interest rates in recent weeks, most leading economists have changed their tune. They've stopped debating "if" the Fed would increase rates and started guessing "when." This talk is likely to heat up even more as we approach the next Federal Open Market Committee meeting on June 29-30. And the credit markets believe that a rate rise is inevitable, as well. Based on futures contracts at the Chicago Board of Trade, the market is betting--with 86% certainty--that Alan Greenspan and crew will bump rates up 25 basis points at their coming meeting and increase rates further through the remainder of the year.

Because few industries are more directly impacted by interest rates than banks, any talk in the credit markets immediately spills over to this sector. And almost on cue, a cacophony of Chicken Littles starts clucking that bank earnings will be squeezed because rates on deposits will rise faster than loans. Of course, at other times, investors also bemoan the exact opposite: Banks will be pinched by falling rates because loans will re-price faster than deposits.

For some investors, seemingly any rate environment offers a tidy reason to avoid banks. Frankly, that's fine with me, except that conventional wisdom--if you can really justify calling it "wisdom"--currently doesn't make one iota of sense.

Since the start of the year, investors have steadily sneaked out of bank stocks. The KBW Bank Index--the most followed in the sector--is down 3.5% since January 1, compared with a 1.2% decline for the S&P 500. Because most banks posted strong (if not record) earnings in the first quarter, as well as improving credit quality, this drop-off can be attributed only to interest-rate fears.

This reaction is just plain silly. Here's why: Most banks currently stand to benefit if rates rise.

We dug through the latest quarterly filings of the 10 largest U.S.-based banks and thrifts, based on asset size. We found that seven of the 10 would experience an increase in net interest income if rates increased. This includes firms we currently have a positive view on such as  US Bancorp (USB) and  National City . Some of these firms--such as  Bank of America (BAC)--have been betting on a rate rise for two years or more, only to be dismayed by the Fed's inaction. Earnings for these firms have been pinched slightly over the past several quarters as a result.

So what gives? The credit markets say rates will rise, and investors walk away from the banks that stand to earn more money if the Fed takes action.

For my part, I truly wish that investing in banks could be boiled down to some simplified rule of thumb. But, the sad fact of the matter is that deciding the opportune time to invest--whether in banks or another industry--is complicated. Long-term issues are big drivers in the value of banks, just like any other stock. Getting a handle on these isn't always easy, and at Morningstar, it sometimes causes our valuation of a company or opinion on a firm to differ markedly from other investors'. But, this tack certainly beats taking a knee-jerk reaction to every short-term issue that pops up, and having it fail to make logical sense when weighed against thoughtful discussion occurring elsewhere in the securities markets.

But rather than filter through these and a host of other issues to build a fundamentally grounded bottom-up analysis, banking firms are all too often lumped into one indiscernible blob. As with any complicated issue, it's easier for investors to rely on their "conventional wisdom" rather than earn the real kind by studying the nuances of different firms.

A version of this article appeared May 19, 2004.

Craig Woker does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.