In one way or another, banks earn profits when interest rates go higher. Banks will lend out at one rate of interest, and savings deposits earn a rate of interest over time. Banks will earn that spread, the difference between what a bank pays in rates versus what it earns from its loan portfolios. If interest rates move higher, banks lend at higher rates. But, these banks also pay out at higher rates as interest rates increase. Nonetheless, the spread is where profits lay for banks. So, with interest rates moving higher, one would think profits would be abundant for banks. Unfortunately, in a period where interest rates are moving higher, there are other risks to banks that need to be accounted for.
The main risk in rising interest rates is that banks hold assets. There is an inverse relationship to rising rates and the price of the debt instrument. If interest rates move up then the value of the instrument moves down. So, as interest rates move upward, banks balance sheets move downward. This puts banks in a position to have to hold back on loans to offset their balance sheet declines.
We are seeing this play out as interest rates continue their climb higher and higher. As this is happening, regional banks are being sold all the while investors are heading to the exits to take off risk.
Interest Rates Continue Higher
The US 10-Year Treasury yield has bee edging higher and higher over the past few weeks and months. This is one of the original roots of the risk-off scenario for regional banks.
Regional Banks versus Large Banks
Whereas the regional banks are down some 30% YTD, larger banks are up almost the same. Why? The reason is simple: Larger banks have larger portfolios and are generally more diversified than smaller regional banks. These larger banks will hedge differently and offset losses in one area of their respective business with profits from another. This is evident when you look at profit growth from in another.
For the past period of time, from 2017 until now, large banks have outperformed their regional counterparts by a differential of 60% – an astoundingly large outperformance. This begs to question that if during the same period of time, if profits declined for large banks to the tune of bringing the period of time performance to 0%, would the regional banks drop to -60%? The possibility does exist.
But, you would have to ask the question of what would first drive the larger banks to 0% performance. Certainly, the bigger banks had seen performance levels below 0%. This occurred in 2020 when COVID hit and all stocks were sold off. At that point, regional banks were at 0% growth rate and larger banks and a growth rate of 25%. Both went negative from there and regional banks dropped to -55% growth rate for the period of time.
Now, asking the question what would push larger banks to the point where they again hit 0% growth rate? There would need to be a seismic shift in profits of some sorts on a large scale that would take profits for these bigger banks down. Ever-increasing interest rates could very likely push profits for larger banks downward if the economy contracted too much. This would significantly push downward the regional banks at that point. But, eventually these regional banks would recover.
KRE Stock – What to expect next
I expect that interest rates will continue to pressure higher and higher. Economic data will be hitting over the next two weeks and this should show that there is continued inflation that will push bond yields higher and higher, and this is going to affect the overall economy. Interest rates moving higher are going to pressure regional banks more and more as they do not have the necessary tools to stave off losses in their portfolios like bigger institutions. This will pressure KRE stock lower.
At the same time, I expect that XLF stock – the Financial Sector ETF, is also going to head lower as the economy contracts from higher interest rates and as revenues & profits to bigger financial institutions begin to contract.
This all weighs upon the interest rate outlook driven by inflation and an economy that is still running too hot at these current levels.