Banks Struggle as Rising Yields Fail to Boost Investor Confidence

Despite the anticipation of higher interest rates benefiting banks, the reality has been quite different this year. The Federal Reserve’s continuous rate hikes, totaling 5.25 percentage points over the past 18 months, have not yielded the expected results for investors. The KBW Nasdaq Bank Index has experienced a 40% decline during the same period, leaving investors disappointed.

The negative impact of rapidly rising rates has overshadowed the potential surge in net interest income. Higher funding costs and significant unrealized losses on bank balance sheets have become the focus on Wall Street. This shift in dynamics has caught many investors off guard. “The game has changed,” says Doug Ramsey, Chief Investment Officer at the Leuthold Group. He highlights that the previous near-perfect relationship between bank stock performance and interest rates no longer holds true due to increased competition on deposit rates.

In the past, banks were not pressured to pay depositors more even as rates climbed. This allowed banks to widen the spread between interest-earning assets and liabilities, resulting in substantial growth in net interest income. However, concerns now arise as banks face the need to pay more for deposits. While larger institutions like JPMorgan have been relatively immune to this phenomenon, midsize and small banks are already feeling the impact on their profits.

Additionally, banks are grappling with $558 billion in unrealized losses on their balance sheets due to the declining value of investment securities caused by rising rates. If banks fail to pay depositors more, they risk realizing these paper losses if depositors withdraw funds en masse, as seen with the demise of certain banks in the past.

Furthermore, Ramsey notes that banks have been stagnant in terms of returns for the past 25 years. The recent rate-hiking cycle has further exacerbated the challenges faced by banks, as higher rates have become detrimental to bank stocks. With interest rates expected to remain elevated for an extended period, the pressure on banks is likely to persist.

However, despite these headwinds, there are opportunities for investors. Some banks, such as First Citizens and Western Alliance, are trading at attractive valuations. The upcoming third-quarter earnings reports from JPMorgan Chase, Citigroup, and Wells Fargo, along with other large and regional banks, will provide a better assessment of the sector.

In conclusion, while banks have not experienced the anticipated benefits from rising yields, there are still potential investment opportunities in the sector. Investors should closely monitor the performance of banks and consider the attractive valuations available in the market.