Expectations of rising interest rates are bolstering the shares of regional banks, as a tumble in technology stocks pushes investors to search for assets that could thrive amid higher yields and tighter Federal Reserve policy.
The SPDR S&P Regional Banking ETF was up 2% year-to-date on Friday afternoon, compared to a 6.6% decline for the S&P 500. Gains in some individual bank stocks have been even more eye-catching: Shares of Citizens Financial Group Inc are up 8.4% for the year to date, while shares of KeyCorp are up nearly 9%.
Regional banks make a hefty chunk of their revenues from net interest margins, boosting their appeal as investors increasingly expect the Fed to hike interest rates more aggressively this year to control inflation. The central bank meets next week and is expected to raise interest rates as soon as March.
Treasury yields have risen in anticipation of tighter policy, with those on the benchmark 10-year Treasury up 40 basis points from recent lows.
At the same time, some investors expect the expanding U.S. economy and reduced fiscal stimulus to boost loan growth, helping regional banks post full-year 2021 earnings growth of 70.1%, the seventh-fastest among the 126 subsectors in the S&P 500, according to Goldman Sachs.
“If you want to play the yield curve steepening, then the best way to do that is through regional banks,” said Moustapha Mounah, assistant portfolio manager at James Investment, who has been increasing his stake in companies such as SVB Financial Group.
Though investors expect regional banks broadly to benefit from rate increases, the pace at which the Fed tightens monetary policy could be key. A too-steep trajectory of rate increases may hurt economic growth and eventually weigh on bank earnings, Mounah said, though such an outcome is not his base forecast.
Fed funds futures traders are fully pricing in a 25 basis point hike in March, in addition to three more rate increases by year-end.
In addition to next week’s Fed meeting which concludes on Wednesday, investors await earnings from Zions Bancorp, which is expected to release its latest quarterly results Monday, followed by First Bancorp on Tuesday and United Bankshares Inc and Merchants Bancorp on Wednesday.
The pace of the Federal Reserve’s rate hikes will directly affect revenues in the sector, said Gary Tenner, an analyst at D.A. Davidson & Co. Tenner recently added two more expected rate hikes of 25 basis points to his valuation models for regional banks, bringing his total to four through the end of 2023, he said.
“The impact of higher interest rates is potentially more positive for estimates and returns for regional banks” than so-called universal banks, which also have income from investment banking, he said. Banks in the S&P 500 are up 0.4% so far in 2022.
Besides a too-quick pace of rate hikes, regional bank shares could suffer if a stock selloff that has already pushed the Nasdaq into correction territory accelerates further, raising expectations that the Fed will raise rates at a slower pace to avoid destabilizing markets.
“There’s still this debate in the share price about how much the Fed is going to raise and how fast. If the Fed backpedals then the rally we’ve been seeing here may slow,” said Steve Comery, a research analyst at GAMCO Investors.
Brady Gailey, managing director at Keefe, Bruyette & Woods, believes even two or three rate hikes would be enough for the sector to post above-market earnings growth as loan growth accelerates. He upgraded the regional bank sector to overweight in September.
“They are set to be a big beneficiary of higher rates, but there are other fundamentals that the sector has going for it, too,” he said.
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