Worried About Rising Rates? Make This 'Hated' Sector Work For You

A few years ago, bankstocks were among the most unlovedinvestments . Many of them traded well belowbook value and also sported low price-to-earningsmultiples . Yet a pair offactors has led investors to rapidly warm up to bank stocks.

First, the global economic crisis no longer seems to be a mortal threat to bank's balance sheets. A long-anticipated crisis simply never came to pass. Second, a sense that the U.S. housingmarket -- a key source of bank profits -- was on the mend, has led to expectations of a brighteningprofit forecast.

Indeed, second-quarter results are in from the major banks, and they look quite solid.

A Solid Quarter For Leading Banks

As a result, after a 20% surge in the first half of thisyear (compared with a 13%gain for the S&P 500), bank stocks have rallied further in the early weeks of the third quarter. This continues a trend that has been underway for nearly two years.

Yet behind the scenes, there are several moving parts that might either derail the bankrally , or push these stocks even higher. Here are five keyissues that may affect this group over the next few years.

1. Rising Interest Rates

Over the next few years, economists expect interest rates to start moving higher. "Long rates," such as the yield on the 10-year Treasury, are dictated economic sentiment, and as the economy strengthens, these yields are expected to rise from a current 2.55% toward the 4% level.

"Short rates," which are pegged to the federal funds rate (the Federal Reserve's benchmark interbank lending rate), are not expected to start rising for at least a few more years. (The Fed wants to see unemployment at 6.5% before rates are hiked, as I discussed in a previous column.)

For banks, such a scenario will be a headwind before it becomes a tailwind. Over the next few quarters , banks are expected to suffer from net interest margin compression, which means their profit spreads on loans will narrow as their own short-term borrowing costs rise faster than the average rate of loans they have issued to clients.

Over the longer term , banks start to make up for lost time, as a firming economy means they can charge higher interest rates (relative to their own borrowing costs). Indeed, "net interest margin expansion" is a phrase you may be hearing a lot more in 2014 and 2015.

2. Reduced Refinancing Activity

Banks have benefited handsomely from the multi-year phase of mortgage refinancings. As homeowners locked in lower mortgage rates, they paid out lots of fees to banks, most of which are pure profit. Yet the recent increase in the 30-year mortgage rate to 4.35% (from 3.35% just a quarter ago) has already led to a slowdown in refinancings.

If mortgage rates rise higher in coming quarters, then this high-margin source of revenue will slow even more. Many of the major banks noted this concern on their recent quarterly conference calls, and the coming months will give a clearer read on whether the era of refinancing has officially come to an end.

3. The Housing Rebound

A quick snapshot of housing stocks gives the impression that sales of new and used homes are expected to steadily rise over the next few years.

Indeed, a falling unemployment rate and a wind down of the foreclosure crisis are key factors behind a housing rally. And even if mortgage rates rise higher, the housing affordability index should remain above 140, which is typically a positive level for home buying.

Wells Fargo ( WFC ) , Bank of America ( BAC ) and JPMorgan Chase ( JPM ) are the nation's top three mortgage issuers, and they have the most leverage to a housing recovery.

But will the housing market post a robust rebound, as many anticipate? That question will be answered in the next two quarters, when we find out whether the U.S. economy is getting stronger, pushing up employment rates and consumer confidence, or whether it will stall out in the face of a slowing global economy.

4. Global Exposure

The most remarkable aspect of the recently reportedearnings reports is how events in Europe, China and elsewhere appears to be having little negative impact on U.S. banks. To be sure, these banks have not only reduced their foreign exposure, especially in Europe, but have also deployed betterhedging strategies to mitigatecurrency risk and other dynamics.

Yet the operations of big banks are still closely affiliated with trends underway atFortune 500 companies, many of which have huge global footprints. More to the point, if Europe hits another crisis point, there's no way that bank stocks would remain unaffected. Banks have surely benefited from a benign global backdrop in recent quarters, but real risks remain and need to be monitored if you own bank stocks.

5. Tighter Regulatory Pressures

The Federal Reserve intends to impose tighter capital restrictions on banks, including a requirement that these banks set aside more capital to prevent another crisis like the one we saw in 2008 and 2009. The banking industry is none too pleased about the Fed's proposals, and Congress, which counts on the banks as their top source of campaign funds , my push back against the Fed.

Yet investors shouldn't see such legislation as a red flag. According to Merrill Lynch analysts , "The adoption of the new leverage standard would likely cause some banks to reduce off-balance-sheet exposures." Although, they add that almost all of the major banks (with the exception of Morgan Stanley ( MS ) and Bank of New York Mellon Corp ( BK ) ) could meet tightening capital requirements without the need to cut their dividends or alter their lending practices.

Risks to Consider: While a fresh European crisis has loomed in the past as the greatest threat to these banks, the vigor of the U.S.economic recovery stands as the greatest potential impediment.

Action to Take --> Tally up the headwinds and tailwinds, and a case can be made for a further rally in bank stocks -- assuming the U.S. employment and housing market trends continue in a positive fashion. Yet considering how far these stocks have already risen in the past few years, it's unwise to expect robustgains in the quarters ahead. Indeed, the recent rally appears to reflect the good times still to come, and the wise course may be to lock in gains and wade back in after the next solid pullback with this group.

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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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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