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Earnings reports this week from Canada’s biggest banks could offer an early glimpse as to how rising bond yields will affect this country’s financial institutions.

Fred Lum/The Globe and Mail

Earnings reports this week from Canada's biggest banks could offer an early glimpse as to how rising bond yields will affect this country's financial institutions.

Until early May, benchmark government bond yields in Canada and the U.S. kept sinking to new lows, pulling down the rates that banks charge for mortgages and credit lines. But that trend reversed itself in early May, and the upward move in yields caught fire when the U.S. Federal Reserve signalled in June that it may begin tapering its massive bond-buying program, perhaps as soon as September.

From the start of May to the end of July – the period for which banks will be reporting – the 10-year Government of Canada bond yield skyrocketed by 0.75 percentage points, closing at 2.45 per cent, a level last seen in 2011.

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Banks' profits depend heavily on the spread between the short-term rates they pay depositors and the long-term rates they can charge on loans. Normally such a large gain in long-term rates would allow the banks to earn more money on each new loan.

The extent to which this rise will reach the bank's bottom lines in this reporting period remains unclear. Although mortgage rates have started to rise, the impact on loan growth and profit margins may not be seen until next quarter.

Fierce competition has forced the Big Six to undercut each other on pricing for the past few quarters, hurting their margins. Rising rates can also eat into fixed-income trading profits, delivering a blow to already-volatile capital markets earnings.

Broad measures of the economy have delivered mixed messages. For instance, many observers expected mortgage growth to slow as a result of high levels of consumer debt and tougher conditions for mortgage approval, but July figures showed that home sales were actually higher than in the same month a year earlier.

In this environment, "it is difficult to pre-judge the winners and losers [among the banks] with any significant degree of conviction," Barclays Capital analyst John Aiken noted.

"Significant growth in earnings will be a challenge," he said, adding that there appear to be few catalysts that could convince investors "to suddenly be more willing to pay up for the banks' moderating earnings."

Bank executives have been quick to point out that while profit growth may be cooling, it is not shrinking. The fear has been that the banks would see retail lending suffer as mortgage growth cooled and Canadians cut back on their household debts. Yet profits have held up in recent quarters.

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There is one thing that investors can reasonably count on this quarter: dividend hikes. The country's biggest banks are widely expected to boost their payouts, especially now that they have clarity from regulators on the amount of capital they must hold to cushion against any blows.

The hikes are designed to satisfy yield-hungry investors. Though bank stocks have enjoyed a summer bounce, their gains aren't nearly as enticing as those posted by the life insurance companies or the U.S. banks.

Rob Sedran, an analyst at CIBC World Markets, argued that investors shouldn't be discouraged. "The Canadian banks have not been the favored sector for some time … which can give the impression that they are struggling," he wrote. "They are not.

"Over the past eight quarters, the banks have meaningfully outperformed the [Toronto Stock Exchange], boosted dividends by an average of 14 per cent, and have racked up solid – albeit single digit – annualized growth in both revenue and earnings per share. Conditions are far from ideal, but the banks have been resilient."

Analyst Sumit Malhotra at Macquarie Securities feels the same way, noting that bank stocks aren't losing value as bond yields rise. "We remain positively disposed to the bank sector at this time, particularly when you consider that banks would receive a clear operational benefit if yields continue to rise (as evidenced by recent mortgage rate increases)," he wrote.

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