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Bank Investors Disappointed as Interest Rates Rise

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Andrew R. Michaud

• October 03, 2023

For years, bank investors eagerly awaited higher interest rates, but their hopes have been dashed. Despite the Federal Reserve's increase of the federal-funds rate by 5.25 percentage points over the past 18 months, the KBW Nasdaq Bank Index (ticker: BKX) has plummeted by 40% during the same period. Contrary to expectations, this cycle of rate hikes has failed to generate excitement among investors regarding a surge in net interest income. Instead, Wall Street has been fixated on the negative aspects of rapidly rising rates, including higher funding costs and significant unrealized losses on bank balance sheets.

The Changing Game for Bank Investors

"The game has changed," remarked Doug Ramsey, chief investment officer at the Leuthold Group. "Once you find keys to the locks, they change the locks." Ramsey observed that for almost 12 years prior to this current rate-hike cycle, bank stocks' performance had a nearly perfect correlation with interest rate movements.

According to Ramsey, the previous model operated effectively due to the absence of competition in deposit rates. Even when rates climbed by 2.25 percentage points between 2015 and 2018, banks did not face pressure to increase payouts to depositors. This allowed banks to widen the spread between interest-earning assets and interest paid on liabilities, resulting in ballooning net interest income. Second-quarter earnings reports showcased this benefit, with Bank of America (BAC) experiencing a 14% growth in net interest income to $14.2 billion compared to the same quarter last year. Furthermore, JPMorgan Chase (JPM) and Wells Fargo (WFC) raised their net interest income forecasts for the year.

Concerns About Peaking Net Interest Income

However, there are growing concerns that net interest income has reached its peak now that banks must pay more for deposits. Large banks like JPMorgan have somewhat avoided this issue so far, as savers are willing to settle for lower yields on their savings for the convenience and perceived security of banking with a larger institution. Yet midsize and small banks are already feeling the strain of paying more for deposits, resulting in diminished profits.

The Problem with Banks: Unrealized Losses and Dead Money

Banks are facing multiple challenges that are impacting their performance. One major issue is the $558 billion in unrealized losses that currently sit on their balance sheets. These losses have been caused by rapidly rising interest rates, which have been pushing down the value of their investment securities. If banks don't start paying their depositors more, they run the risk of these losses becoming real if depositors suddenly withdraw their funds. We have already seen this fate befall Silicon Valley Bank, Signature Bank, and First Republic.

Another concern about banks is that they have essentially been "dead money" for the past 25 years. The KBW Nasdaq Bank Index recently closed less than 1% above the average daily close during 1998. This calculation, however, does not take into account any dividends that may have been paid out during that period.

Traditionally, there has been a positive relationship between bond yields and the performance of bank stocks. But Ramsey observed that during this current cycle of rate hikes, the two have started to move in opposite directions. Higher interest rates have actually been detrimental to bank stocks.

Unfortunately for banks, interest rates are expected to remain higher for a longer period of time. This means that the pressure on them is likely to continue. However, despite these headwinds, some banks are currently trading at attractive valuations due to the immense selloff in the sector this spring. First Citizens (FCNCA) and Western Alliance (WAL) are two such banks that have recently been positively highlighted.

Investors will get a better understanding of the sector's overall performance when JPMorgan Chase (JPM), Citigroup (C), and Wells Fargo (WFC) report their third-quarter earnings next week. Other large and regional banks will follow suit in the coming weeks.

In conclusion, banks are facing significant challenges due to unrealized losses and a lackluster performance over the years. Higher interest rates are exacerbating these issues. Nevertheless, there are some banks that are currently trading at attractive valuations, presenting opportunities for investors. The sector's performance will become clearer as more banks report their earnings in the coming weeks.