Forget the Fed and Beware the 'Bear Flattener' for Banks

It has become almost a knee-jerk reaction: When it looks as if the Federal Reserve plans to raise interest rates, buy bank stocks. And investors have, with both fists.

The idea, pundit-icized by just about every pundit who has ever pundited, is that a higher federal funds rate is good for banks because it will increase the net interest margins they make on loans. As a result, shares of bank stocks this year have traced out a path that to some degree matches the market's sentiment toward the Fed's plans. On Tuesday, the KBW Bank Index traded near its highest level since New Year's Eve.

Simple, right? The Fed is planning to raise rates, so buy bank stocks.

Well, not so fast. 

Historically, there really is no "discernible positive or negative impact" on net-interest margins from changes in the federal funds rate, according to analysts Fred Cannon and Allyson Boyd at Keefe, Bruyette & Woods. In fact, net-interest margins actually declined as the Fed started raising short-term rates in 2004, the analysts pointed out. 

Many other factors besides the fed funds rate determine changes in net interest margins, as the analysts pointed out. Because banks tend to borrow at shorter-term rates and lend at longer-term ones, the yield curve -- the difference between long-term and short-term rates --  is the most important thing to watch. And this year, the curve has undergone a "bear flattener," meaning short-term rates rose faster than longer-term rates. So the curve, or spread between the two, has flattened for most comparisons. Here, for example, is the difference between yields on five-year and three-month Treasuries:

Even if you theorize that the increase in the fed funds rate will have a delayed effect, there is no discernible relationship when looking at it with one-quarter and three-quarter lags, according to the KBW analysts. The flattening of the yield curve, however, should put pressure on banks whose mix of loans contain more longer-dated debt, such as mortgages and commercial real estate.  

The interest rate increase in December, the Fed's first in this cycle, had mixed results for banks:

Of 218 banks covered by KBW, 126 experienced an increase in net-interest margin, while 92 experienced a decrease. Overall, the result was a median increase of just two basis points. And that came without much pressure to increase deposit rates, which may not be the case with the fed funds rate as it is lifted further above zero. 

The lesson here, if it's not obvious yet, is that not all banks are created equal and an increase in the Fed's benchmark rate is not a panacea for all lenders. Engaging in a knee-jerk reaction is a good way to end up looking like a jerk.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story: Michael P. Regan in New York at mregan12@bloomberg.net.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net.