Don't Expect Profit to Soar at U.S. Banks After Fed Raises Rates

  • Earnings may disappoint if long-term rates don't also rise
  • `It's not going to be the barn-burner people want it to be'

Is the Fed Rate Hike a Good Thing?

John Kanas wants to be clear: Investors need to lower their expectations that higher interest rates will translate quickly into fatter bank profits.

“Pundits, and the market itself, are drastically oversimplifying the thesis,” Kanas, chief executive officer of Miami Lakes, Florida-based BankUnited Inc., said in an interview, recounting a message he gave to two dozen investors at a Boston luncheon this month. “This may not be the big holiday and celebration that people think.”

John Kanas

Photographer: Victor J. Blue/Bloomberg

Kanas is among a growing group of U.S. bank executives taking to private meetings and public forums to curb enthusiasm as the Federal Reserve prepares to increase interest rates for the first time since 2006. Investors rushed into financial stocks this year, anticipating that a rate hike would enable lenders to bolster margins by charging more for loans while paying little for deposits. Instead, profits may be hobbled by fierce competition and rate-setters who slow the pace of future increases, capping the long-term yields the industry counts on to make money.

Fed Chair Janet Yellen will announce an increase in interest rates Wednesday afternoon, at the conclusion of the central bank’s two-day policy meeting, according to traders. Futures contracts predict a 76 percent chance the Fed will raise interest rates by 25 basis points, or 0.25 percentage point, according to data compiled by Bloomberg. Prices imply another two moves next year.

Golden Era

Interest rates are an important way lenders make money. In the early days of rising interest-rate cycles, lenders typically don’t need to pay out more to depositors. That, coupled with buoyant credit conditions, led investors to anticipate a golden period of earnings, according to Charles Peabody, an analyst at Portales Partners LLC in New York.

The KBW Bank Index, made up of 24 of the largest U.S. commercial lenders, beat the Standard & Poor’s 500 Index by more than six percentage points from May 1 through July 2, as the perceived likelihood of Fed action rose. A swoon in stocks and turmoil in Asian markets flipped that trend, before once more reversing course. From the Fed’s Oct. 28 meeting through Dec. 7, the KBW index outperformed the broader stock index by almost two percentage points.

There are risks, though, particularly if banks have to increase the interest they pay depositors faster than they can raise borrowing prices, a real possibility in an environment where savers have been starved by seven years of near-zero interest rates, or if competition forces them to offer cheaper loans to win business from rivals.

A rapid increase in deposit prices, the biggest factor determining how much banks will benefit, may mean some lenders get a smaller boost than anticipated, or perhaps even lose income, Standard & Poor’s analysts wrote in a Dec. 14 report. And because banks have varying business mixes, not all of them will see the same effects, leaving analysts guessing about which will benefit most.

‘Myopic Focus’

“There is just a complete near-term, myopic focus on rates,” John Crowley, a money manager at Eaton Vance Corp. in Boston, said in an interview. “It’s not as significant as investors think, and that’s what’s going to disappoint.”

The big fear for executives is that slow economic growth and subdued inflation will encourage the Fed to delay future increases, compressing the gap between short-term and long-term rates. Banks earn more when the disparity is wide because they borrow funds for short periods and lend them out over many years, pocketing the difference in yields. A bigger divide lifts net interest margins, a key measure of profitability.

The spread between the yields on the three-month Treasury bill and the 10-year Treasury note was 1.90 percentage points on Dec. 11, the lowest since April 24. It rose to 2.01 percentage points late Tuesday.

Richard Davis, CEO of Minneapolis-based U.S. Bancorp, is among managers who have tempered their optimism. On an April 15 conference call, Davis predicted a “stunning” impact from a rate hike he expected to come this year. Months later he would announce a hiring freeze. By September, he was sounding a more cautious tone.

“Interest rates aren’t going to move quickly, and when they do, it’s not going to be the barn-burner people want it to be,” according to a transcript of his Sept. 17 remarks.

Preaching Caution

JPMorgan Chase & Co. CEO Jamie Dimon also has preached caution, according to Crowley, who recounted meetings his analysts have had with Dimon over the past two months. Joe Evangelisti, a JPMorgan spokesman, declined to comment.

The outlook was a topic of conversation at an investor conference in New York last week, where bank executives took a measured tone. KeyCorp Chief Financial Officer Don Kimble said his management team wouldn’t bet the bank on rising rates, and Capital One Financial Corp. CEO Richard Fairbank said the industry tends to “overdose” on the outlook for net interest income. Regions Financial Corp. isn’t counting on rates to generate growth, CFO David Turner said Dec. 9.

“You’ve seen more CEOs take a more conservative approach,” said Jeff Bahl, who helps oversee more than $7.5 billion including bank stocks at Bahl & Gaynor Inc. in Cincinnati. “That makes sense, especially in a market that is aggressively punishing companies for over-promising and under-delivering."

Michael Hutchens, who helps manage more than $26 billion, including financial stocks, at San Diego-based Brandes Investment Partners, put it more succinctly: “A flat or inverse yield curve is a headwind.”

Loss Reserves

Making matters worse, the credit cycle may turn, forcing lenders to build up loan-loss reserves. Healthy borrowers allowed banks to boost earnings by releasing prior years’ reserves they no longer need. They may soon need to rebuild reserves to cover loan losses in energy lending or credit cards, analysts said.

Christopher Lee, who helps oversee more than $4 billion in financial stocks at Boston-based Fidelity Investments, is more optimistic than some. Many assets, such as commercial and industrial loans, are tied to short-term benchmarks that will increase in line with the Fed’s policy rate, he said. There’s also the possibility that U.S. growth, and with it a higher demand for loans, will spur industry profits.

“If we get an increase in interest rates, we’ll get an opportunity to really differentiate the group,” Lee said.

‘Sweet Spot’

By urging caution, executives are siding with history, according to Matt Burnell, an analyst at Wells Fargo & Co. In the three prior cycles of rising rates -- 1994, 1999 and 2004 -- bank stocks outperformed the broader market heading into the increase, and then faltered when a rise in short-term rates wasn’t followed by an equal increase in longer-term yields, he said.

Will this time be different? The Fed’s delay in raising rates may have erased some of the industry’s advantage, and the period of strong earnings investors were anticipating may have shortened to as few as two quarters from as many as six or eight, Peabody said.

“I wouldn’t say the sweet spot is ended,” Crowley said. “It’s tied to the original premise of rates and the yield curve steepening. That’s what’s changed: The lower-for-longer assumption has just become stronger.”