Domestic banks are incredibly well diversified, but the yield curve has not been kind to the core business of borrowing funds at short-term interest rates and lending them to Canadians at higher, longer-term rates.
In short, there's a good reason that bank stocks are cheap.
The two primary sources of funds for banks, where the money comes from for mortgages and other loans, are deposits and short-term debt markets. This money is cheap for the banks – the interest rates banks pay on savings is extremely low and the interest rates they pay by issuing short-term debt is similarly small.
The problem is that longer-term rates, the interest banks charge to borrowers, is also extremely low. The difference between the banks' cost of funds and the rate they receive on loans determines their profit. The tiny difference between these rates in the current market – only 35 basis points as of Friday – is proving a significant hurdle to profit growth and stock performance.
The accompanying chart shows the year-over-year return on the S&P/TSX Bank Index compared with the difference between the three-month government money market rate (a proxy for the cost of funds in short-term debt markets) and the five-year government of Canada bond yield (as an estimation of the interest rate lenders charge on mortgages and other loans).
From early 2005 until the financial crisis, the steepening three-month to five-year part of the yield curve successfully predicted outsized year-over-year returns for investors in bank stocks until 2010. Since September, 2013, however, the trend has worked the other way. The steadily flattening yield curve has preceded bank performance lower. Declining earnings from lending have been reflected directly in stock performance.
Lending is not the only business banks use to generate profits. Brokerages, insurance, credit cards, investment banking and capital markets are all examples of operations that can compensate for the drop in profits from lending.
But lending remains the central engine of profit at any bank and the poor conditions for issuing loans are the most likely reason for bank stocks trading at their cheapest valuation levels since the financial crisis. In terms of average price to tangible book value ratios, the domestic banks are trading at 2.1 times, a far cry for early 2011 when the ratio was 3.3 times.
Canadian banks have well-deserved reputations for pulling rabbits out of their hats where profit is concerned, and there is no doubt that they will continue to generate billions of dollars in profit every quarter. But Canadian investors have become accustomed to this profit growing at a significant rate, often more than 10 per cent in year-over-year terms. That era might have come to an end, at least until the yield curve steepens and profit from lending improves.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market online. Subscribe to Globe Unlimited at globeandmail.com/globeunlimited.