Canada Banks’ Profits Poised to Rally as Rates Rise

Photographer: Norm Betts/Bloomberg

Bank of Montreal Chief Executive Officer William Downe, 61, said in an Aug. 27 telephone interview that the downward pressure on margins is "generally past us". Close

Bank of Montreal Chief Executive Officer William Downe, 61, said in an Aug. 27... Read More

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Photographer: Norm Betts/Bloomberg

Bank of Montreal Chief Executive Officer William Downe, 61, said in an Aug. 27 telephone interview that the downward pressure on margins is "generally past us".

Toronto-Dominion Bank (TD) and National Bank of Canada (NA), trading at record highs after posting earnings this week that topped analysts’ estimates, are poised to rally further as rising interest rates make mortgages and car loans more profitable.

Canada’s six biggest lenders had combined profits of C$8.05 billion ($7.6 billion) in the fiscal third quarter, down 1.7 percent from a year earlier, even with net interest margins close to a four-year low. With borrowing costs rising as the economy rebounds, bank earnings and share prices should move higher, according to analysts including Sumit Malhotra at Macquarie Capital Markets.

“There are signs in the latest quarter of emerging margin stability for the banks, in part due to the increase in bond yields,” said Malhotra, in a phone interview yesterday. “While this stabilization is a start, we think the real benefit for the group will be seen when short-term rates start to move higher.”

The Standard & Poor’s/TSX Commercial Banks Index rose to a record high yesterday after Toronto-Dominion, Canadian Imperial Bank of Commerce and Royal Bank of Canada reported earnings that beat estimates. Gains in asset management, consumer lending and investment banking drove earnings higher for the Toronto-based banks, even with depressed margins. The bank index has gained 6.4 percent this year, almost triple the increase for Canada’s main index.

Laurentian Bank of Canada (LB), the only Canadian lender to miss analyst estimates this week, reported a profit decline of 5.7 percent today.

Interest Margin

The average interest margin, or the difference between what a bank charges for loans and pays out in deposits, was 2.04 percent for the quarter ending July 31, a six basis point decline from last year. That compares with about 1.9 percent in 2009, a year of record lows for overall bank margins, according to Scotiabank research.

Executives at Canadian Imperial, Bank of Montreal, National Bank and Toronto-Dominion said the period of narrowing margins is over as consumers continue borrowing as rates rise.

The downward pressure on margins is “generally past us,” Bank of Montreal Chief Executive Officer William Downe, 61, said in an Aug. 27 telephone interview.

CIBC, which relied on Canada for about 87 percent of revenue last year, reported a margin of 2.63 percent in its Canadian consumer and business unit in the third quarter, up six basis points over the same period last year. Margins at TD, BMO, Bank of Nova Scotia (BNS), National Bank, and Royal were little changed.

No Threat

“Right now there’s no real threat to the net interest margin,” said Bob Decker, a fund manager in Toronto at Aurion Capital Management, which oversees C$6 billion including bank shares, in an Aug. 27 interview. “That compression is behind them.”

Canadian benchmark 10-year bond yields rose to a high for the year of 2.75 percent on Aug. 21, from a low of 1.67 percent on May 2. The note rose yesterday, pushing the yield down two basis points to 2.6 percent.

Rising bonds yields are driving some borrowing costs higher, even as the Bank of Canada is forecast to maintain its target rate for overnight loans at 1 percent into 2014, according to data compiled by Bloomberg.

Banks including Royal Bank and Toronto-Dominion, the two largest lenders, have raised mortgage rates to reflect higher yields in the bond market. The average five-year fixed mortgage rate rose to 5.3 percent on Aug. 28, from 5.1 percent the week before, according to the Bank of Canada.

Wider Margins

Spreads for all Canadian lenders will start widening in the first quarter of 2014, according to John Aiken, an analyst at Barclays Plc in Toronto. TD and CIBC will have the highest exposure to interest rates in 2014 while Royal Bank and National Bank will have the lowest, he said in a phone interview Aug. 27.

TD’s net margins will improve in 2014 and 2015 as loan growth will be “well above” the industry average in a rising rates environment, said RBC Capital Markets analyst Andre-Philippe Hardy, in a note to clients yesterday. He updated his price target for the company, raising it 12 percent to C$104.

A resilient housing market may also contribute to wider margins. While economists called for a soft landing in 2013, the latest housing data points to a healthy industry. In July, 39,195 housing units were sold across the nation, a 9.4 percent rise from the same period last year. Housing prices continued to advance, with values up 8.4 percent, according to Canadian Real Estate Association.

‘Chicken Little’

“The whole ‘Chicken Little’ scenario affected a lot of market participants,” Aiken said. “We’re growing confident that housing will not have a major correction. The market looks to be in balanced territory which means consumers will continue to borrow.”

Canadians’ ability to borrow relies on employment, which data indicates is stable. The unemployment rate declined to 7.1 percent in the second quarter of 2013 from 7.3 percent in the same period last year, and down from 8.5 percent in September 2009.

“Despite the low interest rate environment you’re seeing some good volume growth on loans and deposits,” Tom Lewandowski, an analyst at Edward Jones & Co. in St. Louis, said in a phone interview yesterday. “If you talked to me 18 months ago, I would have told you that the Canadian consumer just can’t continue to borrow as they have. But it isn’t slowing down.”

Consumer Debt

Canadians remain leveraged with near record household debt-to-disposable income of 154.3 percent, potentially slowing bank loan growth in the quarters to come. The country’s economy is also forecast by economists to grow next year at a slower pace than the U.S.

“Low interest rates are -- at the short end in particular -- around for a while,” Colleen Johnston, chief financial officer at TD, said in a phone interview yesterday. “What that means is there is fundamental downward pressure -- I’d say it’s modest. As we get through 2014 in Canada and assuming rates start to rise, you will see margins start to stabilize in my view and potentially improve.”

To contact the reporter on this story: Katia Dmitrieva in Toronto at edmitrieva1@bloomberg.net

To contact the editor responsible for this story: David Scanlan at dscanlan@bloomberg.net

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