What Will Be the Effect of Higher Interest Rates on Financial Stocks?

Although bond prices are staging a mild rally this morning in the wake of today's weak employment report, the course of interest rates seems to be undeniably higher.

The yield on the 10 year Treasury note poked above 3% earlier this week for the first time since July 2011. 

The yield on the 2 year Treasury note moved higher than 0.50% for the first time in a couple of years despite recent Fed announcements that point to a continuation of low short term rates for at least another year.

As the chart above shows, financial stocks have been strong performers over the past couple of years.  Using the Financial Sector exchange-traded fund (ticker: XLF), financial stocks have risen over +60% over the past two years compared to +42% for the S&P 500.

Bank stocks have benefited from a number of tailwinds.  Investor sentiment on the group was negative in the wake of the 2008 credit crisis, and valuations were at historic lows.  In addition, with the improvement in housing, mortgage volumes increased dramatically, as did other lending business.

Can the good relative performance continue?

Erika Penala of Merrill Lynch was in town earlier this week to discuss her views on bank stocks.  I have written about Erika on several occasions on Random Glenings, as I find her to be one of the most insightful bank analysts on Wall Street.

Erika pointed out that the effect of rising interests on bank stocks is more nuanced than many investors believe.

She noted that while many believe that a rise on longer term rates are always good for banks, if interest rates on short maturities increase by the same amount or more the effect on banks could be negative.

She distributed a handout titled "Debunking 8 Interest Rate Myths".  While all of her points were interesting, I thought I would highlight three:

• Over 50% of a typical bank earnings are NOT priced off long rates.  The simple view that rising rates on longer maturity assets like mortgages is not necessarily a prelude to robust earnings;
• Rising rates are not always good for bank stocks.  Historical evidence has been mixed, and the sector tends to underperform when short rates rise and outperform when the yield curve steepens.
• Rising interest rates do not always generate more bank revenue.  Bank revenue growth historically has been disconnected from rising interest rates on longer maturity bonds.  In addition, higher long rates could mean lower mortgage banking revenues.

Erika also reported that she had visited Wells Fargo in San Francisco a couple of weeks ago.  Wells is the largest mortgage lender in the United States, but they reported that mortgage volumes have dropped dramatically in recent weeks in the face of higher interest rates. While Wells felt comfortable that other parts of their business should help maintain earnings, there is no doubt that higher rates are hurting.