Federal Reserve Analysis: How Financial Stocks Are Effected

Interest Rates Hit Financials

Interest rates have taken a tumble since there high last October, with the 10 yr Treasury bond yield down almost a full percentage point. The 10 yr is trading at its lowest yield since 2017 and could have more room to fall (10 yr Treasure yield chart below from Market Watch). It is becoming an unfavorable credit environment for lenders, and financial stocks are taking a hit because of it.

Interest income makes up a considerable portion of our favorite bank stocks' income: JP Morgan Chase's JPM revenue is 50% driven by interest, Bank of America BAC relies on interest income for over 50% of revenue, Goldman Sachs GS , whose focus is investment banking, still relies on interest for about 40% of its income. Since the Fed started their dovish campaign at the end of 2018, bank stocks have taken a hit. You can see this in the 1-year performance chart below. These banks have far underperformed the broader equity market, all having negative 52-week returns.

Federal Reserve Overview

The Federal Reserve has two ways of controlling interest rates in the US: one is through their balance sheet, and the other is the Fed Fund rate (monetary policy). The Fed uses their almost $4 trillion balance sheet to influence interest rates by buying and selling fixed income instruments (quantitative easing and tightening).

When the credit market fell apart in 2008, the Fed was forced to buy up the toxic assets in order to keep the credit markets afloat. Mortgage-backed securities aka collateralized debt obligation (CDOs), which started to see defaults in 2008, were quickly losing value and requiring higher and higher yields. These defaults caused a domino effect in the markets. The initial reaction was for people to get out of the riskier equity market and into safer fixed-income assets (flight-to-quality) which caused an initial spike in bond prices and drop in yields. This didn't last long. Investors quickly started requiring higher yields for fixed income assets because of the perceived systemic concern in the credit markets caused by the CDOs. The Fed had no choice but to start buying up a substantial number CDOs to keep credit markets from restricting too much cash flow. By buying these assets the Fed effectively lowered interest rates. This method of monetary policy is called quantitative easing.

The Federal Reserve stopped growing their balance sheet at the end of 2014 hitting an all-time high of $4.5 trillion (up from the $800 billion before the credit crisis). At the end of 2017, the Fed started rolling fixed-income assets off their balance sheet, driving interest rates up. This is a method of monetary policy called quantitative tightening. Below is a chart showing the size of the Feds balance sheet since the financial crisis (from the Federal Reserve's site).

The Fed Funds rate is the overnight rate the Federal Reserve charges banks to meet their cash reserve requirements. The Fed Funds rate is the benchmark interest rate for all fixed income assets in the US and is the principal way in which the Fed controls interest rates.

The Federal Reserve has a dual mandate of keeping unemployment low and controlling inflation. Recently though the Fed has been taking cues from the stock market.

Feds Most Recent Move

The equity market took a tumble at the end of 2018, and the Fed responded with dovish policy. They recently announced that they wouldn't hike rates for the foreseeable future and that they would be stopping their balance sheet roll-off (stop quantitative tightening). These announcements both knocked yields down and caused a surge in prices in both the equity and bond markets.

Unfortunately, bank stocks and their substantial interest income, are heavily impacted by the Federal Reserve's monetary policy. Currently the market isn't just pricing in no more rate hikes but a potential rate cut. The Fed Watch Tool, created by the CME, illustrates that the markets have priced in a 2/3 chance that there will be a rate cut in 2019.

All this dovish news makes me very hesitant to get into any banks stocks right now. Although, if these rate cuts are already priced into the financial sector and they don't come to fruition we could see some larger gains from our bank stocks this year. JPM, BAC, GS - Zacks Rank #3 (Hold)

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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