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.

A Few Thoughts On Cyprus

This note from last week's Economist magazine makes an important point about the Cyprus banking crisis (I added the highlight):


Cyprus is odd, because virtually all its banks’ liabilities are deposits (as opposed to longer-term bonds). Yet, of the 147 banking crises since 1970 tracked by the IMF, none inflicted losses on all depositors, irrespective of the amounts they held and the banks they were with. Now depositors in weak banks in weak countries have every reason to worry about sudden raids on their savings. Depositors in places like Italy have not panicked yet. But they will if the euro zone tries to “rescue” them too.

http://www.economist.com/news/leaders/21573972-bailing-out-cyprus-was-always-going-be-tricky-it-didnt-have-be-just-when-you

The fact that the European Central Bank (ECB) is going to force depositors, not taxpayers, to take losses in return for an ECB bailout may mark an important change for investors to consider.

Here's the take of Gemma Godfrey, head of investment strategy at Brooks Macdonald and a frequent CNBC commentator:

So what does this mean for investing? Two interesting outcomes. Firstly, we may see a wider divergence within the banking sector as greater scrutiny over capital adequacy rewards some and punishes other. Funding costs within the periphery are unlikely to ease. Secondly, it casts a severe shadow over the value of stress tests to gauge the safety of investment in a bank. Cypriot banks passed tests in 2011, which raises doubts over the veracity of the Fed’s own investigations which led to 17 out of 18 US banks passing. Optimism in both cases could be argued as too high.

With the Fed likely to remain accommodative, bullish market sentiment may continue to overshadow concerns elsewhere. However, Cyprus has highlighted that we’re far from an end to the crisis.

http://theinvestmentinsight.wordpress.com/2013/03/28/3-ways-cyprus-is-a-game-changer-for-europe/

Much of the blame for the Cyprus crisis has been blamed on Russian "flight capital" seeking an offshore haven.

However, columnist Heidi Moore writes in the London Guardian that wealthy Russians had known of the bank problems in Cyprus for months, and had been moving assets to other safer locales, including New York:

The meltdown of the Cypriot financial system came as no surprise to well-connected, wealthy Russians, who bundled some of their money to the United States. "Many of our clients had a heads-up on this issue," said {New York attorney} Mermelstein. "Cyprus had started having the conversations about what it was intending, and that's been going on for half a year." 

That's why some wealthy Russians seemed insulted by the insinuation that the collapse of the Cypriot banking system this week caught them by surprise. Cypriot banks were suffering "substantial outflows" for weeks before the meltdown, according to the country's finance minister, Michael Sarris.

http://www.guardian.co.uk/commentisfree/2013/mar/27/cyprus-wealthy-russians-new-york?CMP=twt_gu

It was only a few years ago that commentators were writing of the ascension of the euro block nations versus the U.S. Now it would seem that the U.S. is the unexpected beneficiary of the turmoil in other parts of the world.

The Implications of the Cyprus Decision

Over the weekend, Cyprus announced that it would be taxing bank deposits in return for a 10 billion euro rescue package from the European Central Bank.  For deposits up to 100,000 euros, the tax would run at 6.75%.  Deposits over 100,000 euros would be taxed at 9.9%.

This is the first time in the euro crisis that bank depositors - and not bond holders  - are being hit. Although the euro zone leaders were initially targeting the reported $18 billion of Russian and other Mafia money on deposit in Cyprus, the fact that the new tax would also be imposed on ordinary citizens has understandably created anger and the possibility of a bank run.

It was just announced that the parliament of Cyprus has delayed voting on the measure (largely because it was unlikely to pass).

Here's what the New York Times reported this morning:

By size, Cyprus’s economy represents not even half a percent of the combined output of the 17 euro zone countries. Yet the impact of this weekend’s decision by European leaders to impose across-the-board losses on bank depositors — from the richest Russian oligarchs, who have increasingly deposited their money in Cyprus’s banks, to the poorest Cypriot pensioners — in return for 10 billion euros, or $13 billion, in bailout money could not be more far-reaching...

But it is one thing to wipe out bond investors and quite another to force a loss on bank depositors, including Cypriot savers who had their deposits insured and, like people all over the world, had the impression that a government-backed savings account was inviolable. 

http://www.nytimes.com/2013/03/18/business/global/facing-bailout-tax-cypriots-rush-to-get-their-money-out-of-banks.html?pagewanted=1

We have seen a growing anger among the European electorate that the wealthy have largely escaped paying the consequences for the recent crisis. Both the U.K. and Switzerland have passed measures attempting to cap banker pay, for example, and now this measure aimed at hitting large depositors.

A wealth tax in this country seems unlikely.  However, a couple of years ago economists Carmen Reinhart and Belen Sbrancia wrote a piece that suggested that confiscation of at least a portion of deposit savings was not without historic precedent.  Here's what Paul Murphy wrote yesterday on the Financial Times Alphaville blog:

A couple of years back, when Carmen Reinhart and Belen Sbrancia updated the concept whereby governments might deal with a problematic mountain of debt by confiscating the savings of their subjects, the discussion was all about the subtle, sleight of hand solutions that might be employed.

Artificially cheap rates of interest might be forced on the embattled sovereign’s debt, local banks might be obliged to buy mis-priced government paper, exchange controls may be erected, and so on. Ordinary people, it seemed, could be financially repressed without realising they were in fact the victims.

There was no discussion back then of outright expropriation or a “tax”, as insured (and uninsured) depositors at Cypriot banks are now being forced to bear.

http://ftalphaville.ft.com/2013/03/17/1425872/beyond-financial-repression/?ftcamp=crm/email/2013318/nbe/AlphavilleNewYork/product

Although Cyprus is obviously a tiny part of the world's economy, the result of this latest move bears watching.

Citicorp

At the end of last year - December 13, 2012, to be precise - I had the chance to talk for an hour over lunch with Erika Penala, U.S. Bank analyst at Merrill Lynch.

It was an unusual opportunity - normally lunches with top analysts are well-attended, particularly when the topic involves an area that has been so difficult to analyze over the past few years. Large group presentations don't easily lend themselves to discussion, which unfortunately means less chance to really focus on the investing issues.

But for some reason - the weather, the holidays, whatever - I was the only attendee that cold day in December. So I had the chance to grill Ms. Penala about her thoughts on the stocks she follows.

Her favorite stock that day was a surprise to me:  Citigroup (ticker: C).

Like many investors, I have always been wary of Citi.  The company has always been too big, too difficult to figure out, and of course had needed massive bailout money from the government during the last credit crisis.

Citi has actually failed three times in my career:  1982; 1997; and 2008.  Each time the government has had to come to its rescue, staving off demise from self-inflicted wounds.

So when Erika suggested that Citi was poised for a strong rebound in performance, I was naturally skeptical.

But over the course of our lunch, I began to understand Erika's enthusiasm for the Citi story.

She pointed to many factors that would help the stock. 

While the company was far from being clear of its credit issues, it had aggressively addressed its problems, selling off poor performing assets when possible or "ring fencing" others.

Headcount too was being drastically reduced, with further reductions likely.

And Citi had probably overreserved for future credit losses in the midst of the market meltdown of a few years ago; when these reserves were adjusted, earnings would benefit.

Erika was also high on new Citi CEO Michael Corbat.  Corbat is a Citi veteran, and had served the company in several capacities over his career.  Erika felt that he would bring a no-nonsense, bottom line discipline to a company long known for its profligacy.

Citi at the time was selling at 50% of book value, reflecting the market's skepticism on its future.  Erika felt that over time its stock price should move close to book value, which obviously promised big gains.

So after that luncheon, I took a look at the company myself, and started buying stock for clients.  Unfortunately, as is usually the case with good ideas, I was not aggressive enough, since Citi has since soared, but still her ideas helped performance.

Usually analyst thoughts do not work as quickly, but in this case Erika was right on the button with her thoughts. 

I had the chance to see CEO Corbat for myself last week at a conference here in Boston, and I was impressed.  I think Erika is right:  he seems to be the right man for Citi at this point.

Erika was in town yesterday for a another meeting with clients, but this time I was not so lucky:  her presentation was well-attended, with probably more than a dozen investors at the lunch.

She remains positive on Citi, but is obviously a little cautious on the next move for C after such a strong move in three months.  Many of the financial levers she anticipated have actually been either pulled or anticipated, and she worries that investor enthusiasm has gotten a little too frothy.

Still, she remains a fan, and thinks that Citi could easily hit the high $50's in a year (it is now trading at $47).