What Rising Bond Yields Mean for Q3 Bank Earnings

As look forward to banks releasing their third-quarter earnings, interest rate risk seems to be playing a bigger role in valuations than the usual company-specific results.

We’re also seeing a shift in the usual dynamics around interest rates and the prospects for individual bank stocks.

The first risk is for higher short-term rates, which typically would be good for bank profits. But today they’ve become a negative because of higher funding costs.

This dynamic can be seen in the significant change in correlations between Treasury bond yields and bank stocks in recent months. The correlation between bank stocks and 10-year Treasury yields has gone particularly negative since mid-August, meaning the two metrics have tended to move in opposite directions.

Further, if rates get high enough, more banks could start breaking, as they did this past spring. In that case, valuations for the whole sector will suffer.

Still, maintaining the current rates for longer (“higher for longer” without going higher than today) is not a bad scenario for the banks. Securities yields will eventually improve, boosting earnings over time. We think the key for bank valuations will be about the “higher” and not the “longer.”

While the banks that survived this past March have proven they are categorically different than the ones that failed, if the Federal Reserve hikes rates high enough, those categories could get blurry. For some banks, such a potential breaking point seems closer than for others.

Another risk is the potential for higher long-term rates because of a knock-on effect related to meeting upcoming regulatory capital requirements.

Typically, banks would want to see an upward-sloping yield curve. If that occurred today, the 10-year Treasury yield would need to increase by more than 1 percentage point. This has the potential to materially increase the unrealized losses on securities on bank balance sheets, and therefore delay how long it takes Category III and IV banks to satisfy upcoming regulatory capital requirements.

How Have Bank Stocks Responded to Earnings?

Heading into first-quarter earnings, which were our first look at bank results since the March 10 collapse of Silicon Valley Bank and the resulting banking industry pressure, our thesis was that the market would reward banks that avoided runs while further punishing banks that were falling apart.

Instead, the market yawned, with the banking sector largely treading water despite most banks under our coverage seeing only a low-single-digit percentage decline in their deposit bases. Our read on this after the fact was that the market was in “wait and see” mode, and was not convinced the turmoil was truly over.

Second-quarter earnings saw a similar dynamic. Earnings weren’t perfect, and most banks lowered their profitability outlooks. However, roughly half the banks under our coverage were able to increase deposits, and the initial market reaction was even more positive than what was seen with first-quarter results.

What to Watch In Q3 Bank Earnings

We think third-quarter results may mark the first time since March 8 that we see guidance for net interest income, or NII, stay stable. We expect some positive reaction to this. However, we also expect bank valuations will need the market to become more confident that the current rate hike cycle is indeed over for an additional rerating higher.

Our base case is that all the banks under our coverage will survive this rate cycle and eventually meet the new regulatory requirements. Our sense is the market is still not entirely convinced. If rates go materially higher from here, our base case could start to unravel for several names. This likely explains a material portion of the disconnect between our fair value estimates and current valuations.

We see the most risk for profitability in Comerica CMA, KeyCorp KEY, and Zions ZION, and the most risk to capital with Truist TFC, KeyCorp, and Schwab SCHW.

While KeyCorp and Zions are riskier in regard to profitability, there are some potential positives. KeyCorp’s unique NII boost between now and the first quarter of 2025 should materially improve the bank’s positioning.

Our impression is that the market does not want to give the bank any upfront credit for this. So, to the extent that the bank can survive and see a material boost to its NII over the next three to six quarters, it could be a positive catalyst. Zions’ NII has shown some surprising resilience over the past two months, bottoming in June and growing in July and August. This suggests earnings pressure may not be as bad going forward as what we saw in second-quarter results.

KeyCorp presents the highest risk for a dividend cut among our coverage, with a dividend payout ratio that is likely to expand into the 80% range, even without additional rate hikes. If the Fed hikes rates again, it could start to push the payout ratio above 100%, increasing the odds of a dividend cut. By the first quarter of 2024, we estimate the improvement in the bank’s NII should buy it the ability to absorb one more additional rate hike before its payout ratio breaches 100%. No additional rate hikes would be the best scenario for the bank.

Top Picks: Wells Fargo WFC, PNC PNC, and M&T MTB. We see all three names as cheap, but without the rate risk of the cheapest names, presenting a more attractive risk/reward profile for investors looking to avoid the biggest risks. However, all banks will have some correlation with rate movements and therefore some rate risk, and if other banks start to break, expect valuations for most banks to suffer.

Top Bank Stock Picks

Wells Fargo

Turnaround story, difficult-to-know turnaround timeline, less rate risk, cheaper than its largest peers.

• Fair Value Estimate: $61.00
• Morningstar Rating: 5 stars
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: Medium
• Forward Dividend Yield: 2.95%

PNC Financial Services Group

More conservative operator, less rate risk than U.S Bancorp USB or Truist TFC, but still mega-regional.

• Fair Value Estimate: $175.00
• Morningstar Rating: 5 stars
• Morningstar Economic Moat Rating: Narrow
• Morningstar Uncertainty Rating: Medium
• Forward Dividend Yield: 4.86%

M&T Bank

More conservative operator, less rate risk than other regionals, higher commercial real estate exposure, but we give it the benefit of the doubt/view it as manageable.

• Fair Value Estimate: $169.00
• Morningstar Rating: 4 stars
• Morningstar Economic Moat Rating: Narrow
• Morningstar Uncertainty Rating: High
• Forward Dividend Yield: 4.28%