Bank Stocks Will Rebound When Interest Rate Expectations Increase

What’s down with banks? Stock prices for the industry have fallen much more than the overall stock market index. The KBW bank index has dropped about 20 percent (as this is being written) from the end of last year, though the S&P 500 is only down nine percent. Banks have been hit worse because of dashed expectations for a rising interest rate environment which experts—and even I—predicted would be a boon to bank earnings.

For most of the past few decades, bank interest payments to depositors were about a percentage point less than treasury bill yields. (Banks didn’t pay interest on regular checking accounts, but you can think of the processing of checks and deposits as implicit interest.) When treasury bill rates fell to near zero percent, banks were unable to keep dropping the interest rates they pay depositors, as the traditional spread would have meant negative interest rates. So banks had less margin than normal. Small checking accounts were unprofitable, as the interest the banks could earn on the deposits didn’t cover the cost of processing checks and mailing out statements.

Expectations that the Federal Reserve would push interest rates up triggered happy times for bank stock investors. September of last year was a setback, as the Fed delayed interest rate hikes. Finally last December, the Fed pushed interest rates up a quarter of a percent, with another percentage point of increase expected over the course of 2016.

What has changed recently is expectations for further interest rate hikes. The weakening industrial sector and financial market turmoil makes it less likely that the Fed will continue pushing interest rates up.

Banks are no weaker today than they were two months ago. The most recent loan loss data shows the best performance since 2006 (though the data pre-date the stock price decline). Total loan volume is growing in all categories. But because of the change in interest rate expectations, bank earnings are not expected to be as high as we previously thought. So stock prices had to fall.