Opus News & Insights

Interest-ing Decisions Ahead for US Banks
Thursday, June 30, 2016

The banking industry has endured a rollercoaster-like week, ranging from the highs following the first of two stress tests provided by the Federal Reserve to the dark hollows after a surprising outcome of the referendum in the United Kingdom, which sent U.S. interest rates down sharply. The 10-YR U.S. Treasury bottom-ticked its lowest value ever recorded early Friday (June 24th) at 1.404%.

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On Thursday (June 23rd), the Fed released the initial results of their stress tests. The point of the Fed’s stress tests is to make it more likely that banks and regulators are ready for the next crisis. By publishing these results, the Fed hopes to instill confidence that the banking system continues to be sound. There were 33 banks tested, all of which were above $50B in assets. Collectively, the results showed that these banks were better prepared to withstand a severe recession than they were roughly a year ago. This test pushed the bank’s balance sheets to the extreme and included scenarios such as a severe global recession, a 5% rise in the U.S. unemployment rate, and a negative yield environment over a short short-term period. At the end of the tests, it was projected that banks would see key capital ratios fall from 12.3% to 8.4%, a figure that would still be considered healthy after such a drastic change in market fundamentals.

Just a few hours after the Fed released its first round of bank “stress test” results, which boosted the KBW Bank Index (“KBWI”) by +3.5%, the industry faced the prospect of a crisis that may test the legitimacy of these binary grades in a real-life scenario.  The United Kingdom voted to leave the European Union, and in the blink of an eye, sent the global economy into frenzy, with the KBWI tumbling nearly 12% over the next two trading days.

Global market stability, one of the Fed’s requirements for meaningful and sustainable rate hikes, has gone awry. The question the market is now considering is not whether or not the Fed will increase rates this year, but whether the Fed may, in fact, cut rates. On March 3rd, according to futures trading on Bloomberg, there was a 40.3% chance of at least one rate hike by the end of the year. Now, trading shows that there is only an 8.8% chance that we will see a rate hike in 2016. Furthermore, the odds only increase to a 30.3% chance when this date is pushed out to September 2017. 

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With expectations of a future interest rate hike now off the table, bank stock prices have been pressured significantly and investors are already pricing in lower future EPS and slimmer net interest margin spreads. Banks that are perceived as asset sensitive have had their share prices impacted more than the average peer group. With increased capital regulations, banks have been sitting on larger-than-normal excess cash balances that in the past they would have continually deployed into the market for loan growth. Now, with a different rate and yield curve environment than previously perceived four months ago, banks can make two different strategic plays that may affect their long-term profitability. If a bank sees a prolonged lower interest rate environment, they can continue to pump their excess capital into loan growth to try to offset their net interest margin compression. Conversely, a bank may believe that this decline in rates is short-term in nature and decide to hold off on deploying capital. The latter would cause short-term pressure from margin compression and lower loan growth, but would be fruitful long-term when positioning their portfolio for an increasing interest rate environment. 

Despite the recent decline in share prices, banks comprise a hefty 20% weight within the Russell 2000 Value Index. We continue to opportunistically look for banks with the characteristics we favor (lower valuation, positive earnings revisions, strong efficiency ratio, favorable relationship between price/tangible book value and ROE), though we are underweight, given our bottom-up approach has not uncovered enough candidates that meet our stringent investment criteria to warrant a market weight.



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