Rising bond yields are typically indicators of stronger economic growth and higher profits for banks. That might not be the case this time, as a 30-year bull market in U.S. government debt shows signs of coming to an end.
Higher long-term interest rates can discourage mortgage lending and cause losses in the securities portfolios of banks including JPMorgan Chase & Co. (JPM) and Bank of America Corp. That could be offset only if the rate increases are driven by a growing economy and demand for new credit, rather than speculation about the Federal Reserve slowing its $85 billion-a-month bond-buying program.
“Higher rates without meaningful economic growth are bad for banks,” Paul Miller, an analyst at FBR Capital Markets in Arlington, Virginia, said in a phone interview. “A lot of these banks have put on big securities portfolios at very low rates, trying to put their money to work. If rates move up materially, those things will be marked down.”
Executives at some of the world’s largest banks, including Wells Fargo & Co. (WFC) and Deutsche Bank AG (DBK), are trying to reassure investors that benefits from higher rates will exceed any losses, citing higher returns on new investments and better bond-trading profits. Miller and Chris Mutascio at Keefe, Bruyette & Woods say they’re skeptical because short-term rates that drive loan pricing could stay near record lows while assets pegged to long-term yields lose value.
Banks have bought bonds, whose prices decline as interest rates rise, because they’ve had trouble finding borrowers. Securities made up about 21 percent of the assets at U.S. lenders at the end of March, according to Federal Deposit Insurance Corp. data. The figure has been above 20 percent since the three months ending September 2010. Prior to that, the 20 percent level was last crossed in 2004.
The jump in the 10-year Treasury yield has led to an 18 percent decline in the net unrealized gains that the 25 biggest U.S. banks have on securities classified as available for sale, according to an analysis by Bloomberg Industries. At some lenders, a 2 percentage point jump in the yield on 10-year notes would trim capital levels, said Jennifer Thompson, an analyst at Portales Partners LLC in New York.
A move of that magnitude, accompanied by a parallel rise in short-term interest rates, could cause $4.8 billion of losses in Wells Fargo’s mortgage bond holdings, which accounted for $141 billion or about 57 percent of its debt investments at the end of March, according to the San Francisco-based lender’s quarterly securities filing. JPMorgan faces as much as $15 billion in losses, according to a Feb. 26 presentation.
At Bank of America, it could take three years to make enough net interest income to replace lost capital, Chief Financial Officer Bruce Thompson said June 11. While banks don’t have to recognize gains and losses on bond investments they hold for sale in the income statement, accounting rules require the change in value to be reflected in equity.
Spokesmen for JPMorgan, Bank of America, Citigroup Inc. (C) and Wells Fargo, the four largest U.S. banks by assets, declined to comment, as did Deutsche Bank, Germany’s largest.
Speculation that the Fed will trim its purchases of Treasuries and mortgage-backed securities drove the yield on the 10-year Treasury note to 2.13 percent on June 14 from 1.63 percent last month. The two-year note rose to 0.27 percent from 0.20 percent. The Fed will reduce the pace of its bond-buying before the end of the year, according to the median estimate of 59 economists surveyed by Bloomberg News earlier this month.
One of the biggest challenges for banks is that interest rates on maturities less than 365 days haven’t risen in line with those of longer durations.
The central bank has said it won’t raise its target for the Fed funds rate, currently a range of zero to 0.25 percentage points, until the U.S. jobless rate falls to 6.5 percent. The measure rose to 7.6 percent in May from 7.5 percent the prior month as more people joined the labor force, according to a June 7 Labor Department report. The Fed is also watching to make sure that the inflation outlook doesn’t exceed 2.5 percent.
The disjointed movement of rates has resulted in a steeper yield curve, which shows what it costs to borrow money for different lengths of time. A steeper curve with higher long-term rates would hurt the value of long-term assets acquired when yields were lower.
Absent a surge of economic growth and job creation, there’s no sign that short-term and longer-term rates will rise in parallel, and short-term rates have a bigger impact on bank profitability, analysts including Mutascio said.
Home-equity loans, credit card rates and working capital lines of credit to businesses are among bank assets pegged to short-term borrowing costs such as the prime rate, Fed funds rate or the London interbank offered rate, known as Libor (US0003M), said KBW’s Mutascio, who’s based in Baltimore.
“There’s kind of a general view that the 10-year Treasury yield rising is significantly beneficial for the banks,” Mutascio said in a telephone interview. “That’s not nearly as beneficial as if short-term rates were rising.”
Thirty-day federal funds futures contracts for delivery in July 2015 yielded 0.53 percent on June 14, indicating investors expect the central bank to raise its benchmark interest rate a quarter of a percentage point by then.
“I can’t imagine anyone with an IQ above 100 thinks that short-term rates are going up in the near term,” Richard Kovacevich, Wells Fargo’s former chairman and chief executive officer, said in a June 5 telephone interview. “And everyone with an IQ above 100 believes long-term rates will go up before short-term rates do.”
While a rise in 10-year yields is often followed by a faster-growing economy and an increase in the overnight lending rate, the market has been caught wrong-footed in recent years.
In the first six months of 2009, the yield climbed from 2.05 percent to 3.95 percent as some economists expected government stimulus spending and Fed bond buying to stoke inflation. Yields surged again in late 2010 and early 2011, rising to 3.74 percent from 2.38 percent, after a second round of Fed purchases spurred similar fears.
The U.S. economy grew at a 2.4 percent annualized rate in the first quarter, below its 50-year average of 3.1 percent.
There’s also concern among bankers that the Fed may not be able to control the speed of any increase. While rising bond yields will be “very healthy” for markets, the Fed has to get the pace of the increase right, said Anshu Jain, Deutsche Bank’s co-CEO, at a June 4 investor conference in New York hosted by his Frankfurt-based company.
The return to more “normal” interest rates is “going to be scary, and it’s going to be kind of volatile,” Jamie Dimon, CEO of New York-based JPMorgan, said June 6 during a panel discussion at the Fortune Global Forum in Chengdu, China.
Volatility, a measure of swings in security prices, rose to 84.8 on June 6, the highest since June 2012, according to the Bank of America Merrill Lynch MOVE index. The gauge, which is based on prices of over-the-counter Treasury options, has averaged 62.4 over the past year.
The danger is that higher rates will squelch already weak demand from borrowers and cut off an economic recovery, analysts including Miller said. Business loans have risen less than 1 percent since the end of March to $1.55 trillion, according to Fed data through May 29. Consumer loans rose 1.4 percent during that time to $1.14 trillion.
Rising bond yields also negate one of the benefits of the Fed’s bond purchases, lower mortgage rates, FBR’s Miller said. Homeowners took advantage of falling rates to refinance home loans. Reversing that trend will curb profits from new and refinanced mortgages, since borrowers will take out fewer loans if they have to pay more, he said.
If rates just stay where they are, mortgage originations “are probably going to tail down through the rest of the year,” Wells Fargo CFO Tim Sloan said at a June 11 investor conference, citing refinancings that accounted for three-quarters of all home loans in 2012, according to the Mortgage Bankers Association. The bank made $109 billion in new mortgages in the first three months of this year, a 22 percent decline from the peak quarter that ended in September. Wells Fargo was the largest U.S. home lender in 2012, making about one of every three mortgages.
“The market is scrambling right now,” asking how banks can adjust, said William Fitzpatrick, a Milwaukee-based analyst at Manulife Asset Management, which oversees $248 billion in assets including shares of financial firms. “What they’re saying is ‘Yeah, we know it’s coming, we know we’re going to take a hit in certain parts of our balance sheet, but we’re preparing for that and we’re trying to generate some offsets.’”
Bankers do have some options. Sloan told investors at the Deutsche Bank conference that idle funds and short-term investments, about $160 billion at the end of March, could be reinvested at more attractive yields as rates rise.
Bank of America, based in Charlotte, North Carolina, expects interest income to help offset losses, CFO Thompson said. The lender would collect $1.6 billion in added net interest income if long-term interest rates rose 1 percentage point, without a concurrent rise in short-term yields, according to its quarterly securities filing. JPMorgan would bring in about $2 billion in added net interest income if long-term rates rose 3 percentage points, the Feb. 26 presentation shows.
Analysts and investors have pressed banks about when to expect a turnaround in shrinking interest income and the net interest margin, the spread between the rate banks pay to borrow and what they charge to lend. The widely followed measure of profitability fell to 3.27 percent at U.S. banks in March, the lowest since 2006, according to FDIC data.
The prospect that rising interest rates may fatten spreads led some investors to buy bank stocks, said Ralph Cole, a senior vice president of research at Portland, Oregon-based Ferguson Wellman Inc., which manages $3.1 billion, including shares of New York-based Citigroup Inc.
The KBW Bank Index (BKX) of 24 companies rose 8.3 percent in May, its largest monthly gain since March 2012, dwarfing the 2.1 percent gain for the Standard & Poor’s 500 Index. Both indexes have declined in June.
Top performers over the past 12 months include Citigroup, Bank of America and JPMorgan. Those lenders have large bond-trading units that may profit from higher trading volumes that come with a rise in yields. Deutsche Bank’s Jain told investors at the bank’s conference June 4 that revenue would be buttressed at the fixed-income, currency and commodity unit.
“I would much prefer, and Colin Fan and his team would much prefer, a steeper curve, higher volatility, bigger volumes,” Jain said, referring to the executive who co-leads the investment-banking unit. “If we sat here Japan-like for the next five years, that’s a more challenging environment.”
Still, not all bank executives are calling on the Fed to raise short-term rates. The Federal Advisory Council, a group of bankers including Morgan Stanley (MS) CEO James Gorman who advise the central bank, warned officials last month that increasing interest rates could “damage” the housing recovery that has helped bolster U.S. economic growth.
“There are pockets of business that I’m sure are going to benefit,” said Fitzpatrick, whose firm owns shares of Deutsche Bank. “But the punch line is that in traditional banking land, a rise in long-term bond yields that’s not accompanied by a rise in short-term rates is going to be painful.”