I’m Still Bullish on Bank Stocks – Here’s Why
Bank stocks have had a really good run higher lately, but last week and early this week, they’ve been hit hard as investors seem to be fleeing the country’s biggest and most profitable bank names.
Those investors are making a huge mistake – and I hope you’re not one of them.
In fact, now’s the best time to buy bank stocks.
Why Investors are Skittish
The overhanging fear bank stock investors think they’re facing is the expiration of an exemption the Federal Reserve gave big banks last year.
The one-year exemption was a pass on having to count U.S. Treasuries in the calculation of banks’ supplementary leverage ratio, or SLR, and it’s currently set to expire on March 31, 2021.
Banks have stringent reserve requirements, which got beefed up after the disastrous Financial Crisis of 2008. One additional calculation forced on them is the SLR, which requires banks to count all their “assets” when calculating how leveraged their capital is against those holdings.
As far as assets go, U.S. Treasuries and junk bonds have the same “weight” in SLR calculations.
With the pandemic hitting markets and the economy, the Fed in March last year decided to exempt Treasury holdings at big banks from being incorporated in their SLR calculations. That way banks would be less constrained in their reserve requirements and could lend more into the economy where money was needed.
Not having to add government bills, notes, and bonds in their SLR calculations allowed banks to add huge amounts of those assets at precisely the same time they knew the Fed was going to do everything in their power to lower rates.
Since lowering rates increases the price of bonds, the huge addition of Treasuries to banks’ balance sheets and the exemption afforded them guaranteed them some tidy profits as the Fed drove rates down.
Bank stocks have also been huge beneficiaries of the recovering economy, especially as part of the so-called “rotation into cyclical stocks” trade. And with the Fed promising to keep rates low, but longer maturity rates, principally the U.S. 10-year note, rising, investors saw the steepening yield curve as another positive for banks.
A rising yield curve, which means rates on the short end of the yield curve are very low, but the further out you go on the maturity spectrum, rates tend to rise, sometimes steeply – meaning greater net interest margin, or NIM, for banks. NIM is the spread banks make when they borrow cheaply on the low end of the interest rate curve and lend money out at higher rates for longer periods of time.
The much-anticipated Fed statement last week about projections and decisions made in their quarterly two-day Federal Open Market Committee get-together said nothing about the soon expiring SLR exemption. In the press conference that followed the Fed’s statement, Chairman Jerome Powell refused to answer a question about the expiring exemption, instead saying there would be an announcement coming. Investors took that as bad news and started net selling bank stocks.
And sure enough, Friday last week the Fed said it was letting the exemption expire on its original expiration date, March 31, 2021. And that sparked some hard selling of big-name bank stocks.
But investors aren’t thinking big enough; their short-sighted thinking is that banks won’t be as profitable if they must calculate Treasuries back in their SLR requirements, and worse, since they’ll have to reserve against all the bills, notes, and bonds they bought, they’ll have to sell excess holdings to get their reserve requirements down.
But they’ve got it all wrong.
The Big Picture – Rising Rates Aren’t a Bad Thing
The big picture for banks is painted by the Fed. And given the Fed’s concern and coddling of big banks (who all own a piece of the Fed, by the way) there’s no way the Fed is going to suddenly impact bank liquidity or profitability.
Of course, the Fed’s been talking to banks, monitoring their holdings, and hinting they’ll have to start including Treasuries back in their SLR calculations. There’s no way the Fed would tolerate big banks unloading tens or, collectively, hundreds of billions of dollars-worth of Treasuries into an unreceptive market and push rates a lot higher.
That would be “disorderly,” which the Fed Chairman vowed to not let happen if it looked like rates were going to spike in such a way. So, they wouldn’t purposely force a disorderly dumping of bonds by banks that would spike rates and freak out bond as well as equity markets.
That doesn’t mean there won’t be any net selling of Treasuries by banks, it just means that selling won’t be disorderly to the point of causing rates to spike a lot higher.
Based on my analysis, rates are going higher anyway. And that’s not a bad thing. In fact, it’s especially good for banks and bank stocks.
If rates rise because of growing pains, meaning the economy is growing above trend, that’s natural and indicative of demand for money and credit to expand and consume more. As long as rate increases are orderly, economic participants can adjust to them.
As for banks, remember, a steepening yield curve, which is what happens when rates on the longer end of the maturity curve rise, fattens their net interest margin, meaning their profitability on loans.
Another positive for banks was somewhat hidden in what the Fed said about the expiring SLR exemption, which is they’d be taking another look at the effects it has on liquidity and markets.
I’ll tell you exactly what that means. It means the Fed is going to change how they weigh Treasuries in SLR calculations. After all, it makes no sense that Treasury holdings have the same weight as much riskier junk bonds. Lowering the weight of Treasuries in certain calculations is going to happen, for several reasons, which I’ll explain in another article, but it will have gigantic implications.
For banks, the implications are obvious, they’ll be able to hold more Treasuries and reserve less against them, which will add to their profitability.
That’s why the selloff on big bank names is a mistake.
This dip is a good time to get into bank stocks to be locked and loaded for their next leg up.
And they do have a lot higher to go. I’ll tell you next time how high that is.
Better still, there’s a subsector of financials that’s going to outshine even the big banks.
Want to know what that is? Stick with me. I’ll have more details for you in the next few days, and I promise it’ll be worth the wait. When it comes to trade recommendations, timing is everything.
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Warm wishes for health, wealth, and happiness,