How Reducing Federal Reserve Bond Purchases Could Help Bank Stocks

The Federal Reserve now says it plans to start scaling back its bond buying program before the end of the year, and bank stocks could benefit. Since July 2020, the Fed has been buying tens of billions of U.S. Treasuries and mortgage-backed securities each month to keep long-term interest rates low. Bank stocks could benefit if tapering does what it’s supposed to do and increases long-term yields, which would be very positive for banks currently in this ultra-low rate environment. Here’s why.

How quantitative easing works

When an economy suddenly goes into recession, the Federal Reserve often lowers its federal funds rate, the overnight bank lending rate, and the central bank’s benchmark short-term interest rate. All long-term rates like those on US Treasury securities are influenced by the federal funds rate. The Fed uses lower rates during a recession because it makes borrowing and lending easier.

But when the federal funds rate hits near zero like in March 2020, and the economy still needs help like it did during the unprecedented coronavirus pandemic, the Fed must resort to others. levers to help the economy. One of them is quantitative easing, which is the purchase of US Treasuries and mortgage-backed securities, which increases the money supply in the economy and keeps long-term rates lower. when the federal funds rate is already zero.

The real prices of bonds like US Treasuries and the yield attached to them move in opposite directions, so when bond prices are high, bond yields are lower. When the Fed buys bonds, it reduces the supply of bonds, pushing up the prices of real bonds, which in turn lowers the yields attached to them. Since July 2020, the Fed has purchased $ 80 billion in U.S. Treasury securities and $ 40 billion in agency mortgage-backed securities each month. Look at the impact on long-term Treasury yields.

10-year Treasury rate data by YCharts

As you can see, long-term returns dropped dramatically at the worst of the pandemic in 2020, and then increased dramatically to start the year. Longer-term returns often reflect the direction short-term interest rates such as the fed funds rate will take. With high projections for economic growth this year, and then for inflation, which typically drives rate hikes, long-term yields soared early this year, but have since fallen significantly.

Why rising long-term yields help banks

For most banks, their main business is credit. Banks also buy securities such as treasury bills to monetize deposits that are not used for loans and to preserve liquidity. Since banks typically borrow money on a short-term basis and provide loans such as mortgages on the basis of long-term rates like the 10-year Treasury yield, higher long-term rates usually improve their rates. profit margins. This can be seen through the difference between the two-year Treasury yield and the 10-year Treasury yield, also known as the yield curve.

10-year Treasury rate data by YCharts

As you can see, as rates were at all-time lows during part of the pandemic, the spread between the two-year rate and the 10-year rate widened, known as the steepening. the yield curve, which is very beneficial for the banks. . However, the steepening has eased somewhat, as growth expectations have slowed in the near term and concerns about the coronavirus variants have kicked in. When the Fed begins to cut its bond purchases, that should push up long-term rates. It could also signal to the market that the Fed is on track to hike the fed funds rate by the end of 2022 or early 2023, as Fed officials have previously said they want to end their program of buying oil. ‘bonds before raising rates.

It would also benefit most banks as it would increase their yields on most loans, which would improve profit margins for banks who can also effectively manage their deposit costs, which also increase with rates. Banks are also expecting some lending growth in the remaining months of 2021 and into 2022, which will give them the ability to extend loans at higher rates. They will also be able to reinvest securities at higher yields.

Not a guarantee

Of course, the market may not react the way it is supposed to. Despite news that the Fed plans to start cutting its bond purchases later this year and rumors about it in recent weeks, the 10-year US Treasury yield has remained weak. Moreover, even when the Fed indicated earlier this year that it may hike the fed funds rate earlier than expected, long-term yields have remained low in recent months.

Why is it? Well, there are many reasons, but the main one is the coronavirus. The delta variant turned out to be more difficult than expected and could be a barrier to higher long-term rates. Recently, data showed US retail sales fell 1.1% in July, from the expected 0.30% drop, largely due to fears over the delta variant. If a new wave of coronavirus cases slows growth and hurts the economic outlook for businesses and jobs, the Fed may need to keep rates lower for longer to support the economy.

How to play it

If the Fed continues its reduction this year, the variants of the coronavirus do not have too much of an impact on the economy and there is modest growth in lending, some banks will benefit more than others as some banks are much more sensitive to interest rates. One of the banks that benefits the most from higher long rates is Bank of America (NYSE: BAC). The bank revealed in a recent regulatory filing that if long-term rates rose 1%, the bank would reap an additional $ 2.7 billion in net interest income over the next year. If the Fed increased its federal funds rate by 1%, Bank of America would see net interest income increase by $ 8 billion over the next year.

Wells fargo (NYSE: WFC) is also very well positioned to benefit from higher rates, as are banks like JPMorgan Chase (NYSE: JPM) and Citizens Financial Group (NYSE: CFG). You can look at bank regulatory documents to see how sensitive individual banks are to interest rates, so do your research and invest wisely, as I believe higher rates across the board will eventually happen.