The Big Long: Bank Trade Gets Liftoff in Stocks as Fed Tightens

The Fed Rate Hike in Two Minutes
  • ETF flows and options volume climbing for financials
  • Banks overtook technology as most favored in fund survey

Seven years after American banks brought the global economy to its knees, stock investors want nothing more than to own them again now that the Federal Reserve is back to raising interest rates.

The country’s biggest financial stocks have surged more than 5 percent in two days, an early payday for bulls who have piled in on speculation the end of zero-percent rates will stoke a profit revival. Securities tracking the industry have attracted $1.7 billion in the past month, the most among 12 sectors tracked by Bloomberg except energy.

Bulls are looking for something that has been elusive -- a rally big enough to erase the losses banks suffered in 2008, their worst year since the Great Depression. The group has been a favorite of global money managers for two months even as stress in the junk bond market evokes comparisons to the subprime meltdown.

The Fed hike “does provide the first wave of relief for the financials and so we have moved to an overweight position in the last two quarters in financials in part with this expectation,” said Leo Grohowski, who helps manage more than $184 billion in client assets as chief investment officer of BNY Mellon Wealth Management in New York. “This is welcome news for the financial sector.”

Fund inflows and the options market show the extent of optimism on banks at the end of an unprecedented stimulus campaign by the Fed. Since mid-November, money sent to stock ETFs such as the Financial Select Sector SPDR Fund has accounted for about a third of the total deposited to all sector funds, data compiled by Bloomberg show.

In the options market, more than 2 million contracts on the financial ETF, known by its ticker XLF, changed hands in the past six days. That’s the highest volume over any comparable stretch since April 2013, data compiled by Bloomberg show.

Traders are also less concerned about price swings in financial companies. The implied volatility for XLF versus an ETF that tracks the S&P 500 is 75 percent below a 10-year average, according to data compiled by Bloomberg on three-month options with exercise prices closest to current price levels.

Bank CEOs have been careful in recent months to tamp down any expectations that slow rate increases will markedly boost interest income. But Wednesday’s move is still important psychologically for consumers and executives, and for international confidence in the U.S. economy, according to Richard Davis, CEO of Minneapolis-based U.S. Bancorp, the nation’s largest regional bank.

“The Fed is one of the most trusted bodies in America,” Davis said in an interview after the decision. The central bank’s view that the economy can bear higher rates, “gives everyone permission to agree that we are now moving forward with the recovery and gives them permission to start thinking about feeling good about growth again.”

While practically every lender is rallying, gains have been led by regional banks, with companies from Fifth Third Bancorp to Regions Financial Corp. and M&T Bank Corp. rising at least 5 percent since last weekend. Among bigger banks, Goldman Sachs Group Inc. has climbed 5.5 percent in three days, the most since September 2013, while Morgan Stanley has risen 4.8 percent.

“Now you’ll see market preference for companies that are able to use this higher interest rate environment to boost their net interest margins,” said John Carey, a Boston-based fund manager at Pioneer Investment Management Inc., which oversees about $230 billion. “We’ll see which companies are really skillful, and which ones are also-rans.”

A revival in financial companies is one of the only bullish things left to happen in a market where $15 trillion has been restored to stock prices over seven years.

While banks and brokerages have posted some of the S&P 500’s biggest gains since markets bottomed in March 2009, the trajectory mostly reflects the speed at which they plunged in the 18 months before that. The financial industry is by far the index’s worst performer since the end of the last bull market, falling more than 30 percent since October 2007 compared with gains of 75 percent or more in consumer, technology and healthcare.

The bull case on banks turns on expectations that higher interest rates will increase the profitability of their lending operations. Earnings for the financial sector of the S&P 500 are forecast to rise 8.1 percent next year, exceeding the rate of the full index. Goldman Sachs estimates the Fed will raise its benchmark rate to 3.5 percent by the end of 2016.

Even if a 25-basis-point change won’t directly affect profit very much, the public’s shift in attitude, “to my investors, is great news because a bank is entirely a reflection of the people we service,” he said.

Wells Fargo CEO John Stumpf, who runs the largest U.S. mortgage lender, said it gives the public more evidence that the economy is moving beyond the financial crisis. Wednesday’s market’s reaction “was a confidence rally,” he said in an interview. “I think the move is more important than the rate. And it says ‘Yes, things are better than they were when we put this exceptional accommodative policy in place.”’

At the same time, concern about the volume of trading on Wall Street has been pushing estimates down for the current quarter. Industry profits are projected to be unchanged from a year ago in the three months ending Dec. 31 after estimates fell at the fastest rate in four years.

While many banks are well positioned to benefit from higher rates, the start of a tightening cycle signals new challenges for the industry, according to Devi Aurora, primary credit analyst at S&P.

“This will present new, but not entirely unwelcome, challenges for bank managements with regard to funding and capital, and the pace of deposit repricing will become a key factor to monitor,” Aurora wrote in a Wednesday note titled “2016 U.S. Banking Outlook: It’s All About That Rate, ’Bout That Rate.” “We expect some shifts and possible repercussions for banks’ funding, balance sheets, and capital.”

After spending the years since 2007 cutting costs and repairing balance sheets, banks and brokerages have become the biggest profit contributor to the S&P 500. They earned a combined $172 billion in the first nine months of the year, more than any other industry over the period. At 1.4 times book value, the industry is cheaper than all others in the S&P 500. The ratio stands at 2.8 for the broad index.

“Financials come up pretty favorable,” Mark Spellman, a fund manager who helps oversee $4.2 billion at Alpine Funds in Purchase, New York, said by phone. “Part of the story is higher rates are going to lead to higher profitability and higher stock prices. You don’t have a high P/E in them, so you’re more comfortable making that bet.”

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