Bank stocks are experiencing their best day in nearly two years, thanks to a significant drop in bond yields following better-than-expected inflation data.
The SPDR S&P Bank ETF (ticker: KBE) saw a 6.5% surge in midday trading, only slightly behind the 6.9% increase it reached on January 6, 2021. This rapid growth comes following the Bureau of Labor Statistics’ announcement that the consumer price index rose by 3.2% in October. This figure is considerably lower than the increases of 3.7% observed in both August and September, and slightly below the anticipated 3.3% as predicted by analysts surveyed by FactSet.
To fully comprehend the positive impact of this development on banks, it’s essential to take a closer look at the intricate workings of our financial system.
The decline in inflation rates essentially relieves pressure on the Federal Reserve to maintain higher interest rates for an extended period. As bond yields are linked to the actions of the Federal Reserve and the perceived future actions by investors, they have fallen in response to this news. At midday, the yield on the 10-year Treasury note dropped below 4.5%, having previously come close to touching 5% the previous month.
Typically, higher interest rates are advantageous for banks, as they enable lenders to generate more income from assets like loans while simultaneously keeping payments to depositors relatively low. However, there is also a potential risk associated with excessively high rates.
During the pandemic, banks experienced a surge in deposits, yet demand for loans remained weak. Consequently, lenders chose to invest in Treasury debt. Ordinarily, this would be considered a safe move. Unfortunately, as the Federal Reserve increased rates to combat inflation, the value of Treasuries plummeted, resulting in collective unrealized losses amounting to $558 billion for banks.
Economic Boost for Banks Amidst Decreasing Deposits and Rising Rates
As the COVID-19 pandemic persists, households and businesses have been depleting their savings, resulting in a decrease in bank deposits. Savers have also come to the realization that they can earn higher interest rates by investing in money-market funds and other vehicles, rather than keeping their cash in bank deposits.
To prevent deposits from draining away, banks have been compelled to offer higher rates to savers. However, this has eroded the margin they earn on loans.
Meanwhile, as bond yields continue to decrease, bank investors are banking on a few factors. Firstly, they believe that the Federal Reserve will avoid tipping the economy into a recession, which would negatively impact loan demand and borrowers’ ability to make timely payments. Secondly, they anticipate that if bond yields remain low, banks will face less pressure from unrealized losses on their Treasury investments. Finally, they expect that banks’ cost of funding, influenced significantly by the amount they pay depositors, will stabilize.
These positive developments provide much-needed encouragement for banks. Despite a surge on Tuesday morning, the KBE index remains down by 21% this year, while the S&P 500 has experienced a 13% increase.
Notably, some banks performed particularly well on Tuesday. Citizens Financial (CFG) witnessed a gain of 6.9%, Fifth Third Bank (FITB) saw an increase of 6.4%, and M&T Bank experienced a rise of 5.9%.