As the financial quarter concludes, the banking sector is approaching another earnings season with a mix of anticipation and anxiety. Despite showing a positive performance in the last two consecutive quarters, the uneasiness among Wall Street circles refuses to abate, chiefly due to unpredictable market dynamics.
- Banks are approaching a new earnings season with Wall Street showing signs of unease due to uncertain market conditions.
- Central focus is on escalating bond yields, driven by the Federal Reserve’s aggressive rate hikes over the past 18 months.
- KBW Nasdaq Bank Index (ticker: BKX) has declined over 20% this year, reflecting the sector’s struggles.
- $558 billion in unrealized losses are on banks’ balance sheets as of Q2’s end due to the diminishing value of investment securities from rising rates.
The Double-Edged Sword Of Rising Interest Rates
This time around, the focal point is the escalating bond yields. A rise in interest rates has been a long-standing desire among banks, aiming to enhance their lending margins. However, the Federal Reserve’s assertive stance on hiking rates in the past one and a half years seemed to be an overzealous move, happening too swiftly.
Initially, the banks relished the advantages of elevated rates, but the joy was short-lived as their funding costs skyrocketed. Alongside, the menace of increased defaults from borrowers due to higher rates added to their woes. Not to overlook the substantial unrealized losses accumulating in their bond assets.
The almost definite scenario of enduring high rates has led analysts at Keefe, Bruyette & Woods to trim down their earnings forecast for 2024 by 3%, given that the KBW Nasdaq Bank Index (ticker: BKX) has slumped over 20% this year alone.
Analysts’ Take On The Upcoming Earnings Season
Entering this earnings season, the analyst fraternity is threading with caution. Christopher McGratty of KBW opined that a mere technical bounce won’t suffice; a consistent positive reevaluation might only transpire when investors harbor greater confidence in the economic trajectory, the future of interest rates, and the cyclical nature of the banking domain amidst a prolonged high-rate ambiance. This scenario underscores the nuanced approach required to trade during earnings season, as market dynamics are poised to shift with every piece of financial disclosure from the banking sector.
Reflecting on the past nine months, the sector has navigated through turbulent waters. The initial quarter saw a debacle with Silicon Valley Bank and Signature Bank, instigating investor skepticism. The subsequent quarter carried the lingering apprehension further, coupled with new regulatory impositions aimed at averting similar calamities.
Presently, with bond yields stealing the limelight, some Wall Street pundits believe the apprehensions might be overstated. Erika Najarian of UBS expressed optimism last Thursday for banks encompassed in the SPDR S&P Regional Banking ETF (KRE), which are typically more dependent on interest income, unlike their larger counterparts that also rake in substantial revenue from fees.
Historical Tussle: Interest Rates And Bank Stocks
Delving into the history, bank investors had long awaited a rise in interest rates. The wait ended but not with the envisioned outcome. The Federal Reserve’s stride in escalating the federal funds rate by 5.25 percentage points over the recent 18 months saw the KBW Nasdaq Bank Index plummeting 40% during the same timeline. Instead of an exhilaration over a probable surge in net interest income, the focus shifted to the adverse facets of swiftly escalating rates – escalating funding costs and substantial unrealized losses on the banks’ financial statements.
Doug Ramsey of the Leuthold Group illustrated a paradigm shift, noting that the once harmonious relationship between bank stocks’ performance and the trajectory of interest rates has veered off course, especially during this rate-hike phase.
The prior allure of higher rates lost its sheen as banks now grapple with paying more for deposits, especially hitting the medium and smaller banks hard. The largest banks have been relatively shielded from this fallout, with savers compromising on yields for the perceived stability offered by these behemoth institutions. However, the soaring deposit costs are denting the profits.
Unrealized Losses: A Brewing Storm
Additionally, a whopping $558 billion in unrealized losses are sitting on banks’ financial statements as of Q2’s closure, courtesy of the soaring rates diminishing the value of their investment securities. Without a hike in what banks offer to depositors, a mass exodus of depositors could force banks to actualize these paper losses, a scenario that previously culminated in the downfall of Silicon Valley Bank, Signature Bank, and First Republic.
Ramsey further pointed out that banks have been essentially stagnant money-wise over the past quarter-century. The KBW Nasdaq Bank Index, as per his observation last month, barely touched 1% above the daily average closing during 1998, disregarding dividends.
The once linear relationship between bond yields and bank stocks’ performance has now diverged, with the recent surge in rates proving detrimental to bank stocks.
As the high rates are here to stay for an extended period, the banking sector’s recent ordeal is predicted to persist. However, the massive sell-off this spring has rendered some banks’ valuations attractive, notwithstanding the ongoing challenges.
The forthcoming week will unveil a clearer picture as banking giants like JPMorgan Chase, Citigroup, and Wells Fargo are slated to disclose their third-quarter earnings, with other prominent and regional banks following suit in the ensuing weeks.
In conclusion, the banking sector is at a critical juncture. The impending earnings season will either allay or exacerbate the prevailing Wall Street jitters. Amidst the swirling market conditions and the specter of enduring high-interest rates, the road ahead for banks seems to be laden with challenges and uncertainties. The eventual outcome hinges significantly on how banks adapt to these testing times, which will not only shape their financial health but also potentially alter the broader economic landscape.