What the Fed-Funds Rate Increase Means for U.S. Financial Stocks
The long term still matters more than the short term to our valuations.
On Dec. 16, the Federal Reserve's Federal Open Market Committee increased its benchmark federal-funds target rate for the first time in more than nine years. We have seen banks and other financial companies swiftly incorporate the changes into their pricing structures. More important, the accompanying Fed statement signaled the pace and magnitude of future rate increases, which is a critical input and driver for our long-term valuations for our financials coverage.
In fact, the long-run level of interest rates is far more important for the valuation of banks than any near-term changes in the fed-funds rate. For example, 80% of wide-moat Wells Fargo's (WFC) value is derived from the company's financial performance beyond 2019. By that time, we assume the yield curve reflects rates consistent with our economywide growth and inflation forecasts. Our cost of capital assumptions for all U.S. companies use a 4.5% risk-free rate--thus, our bank valuations incorporate this rate as a basis for long-term yield assumptions. Similarly, our cost of capital assumptions reference 2.0%-2.5% inflation expectations, consistent with the Federal Reserve's objectives.
Furthermore, although the fed-funds rate is still just 0.25%-0.5% after the quarter-point increase, FOMC members' median "longer run" (post-2018) projection was 3.5% at the last two meetings, so we will continue to use this as a base rate for short-term asset and liability pricing. Thus, even dramatic near-term moves in the fed-funds rate--or long-term interest rates, for that matter--would not result in meaningful changes in our bank fair value estimates. Changes in our long-term economic growth or inflation expectations for the U.S. would be more significant.
Longer term, the larger question for investors in financial stocks is how much the FOMC will ultimately increase rates (magnitude) and over how long of a time frame (extent). Coming out of this last meeting, the Fed indicated that its expected target fed-funds rate will approximate 1.375% by year-end 2016 through four subsequent increases; this provided a framework that the market will incorporate. We expect future increases in the fed-funds rate will be deliberate over a longer time frame. We think the Federal Reserve's mandate for full employment and keeping inflation at 2% will continue to dictate future moves. Overall, we expect small incremental steps upward in rates over an extended period, though the ultimate magnitude of the shift depends on the Fed.
The following provides an overview of the impact of the increase in interest rates on our major subsectors.
Generally, the impact on banks of an interest rate increase is positive. However, the timing and magnitude of the increase may not be felt immediately in the income statements of the U.S. banks we cover. Thus, the impact of a rate increase depends upon a number of factors related to specific bank businesses.
Since a bank's revenue is largely driven by the spread earned between the yield earned on assets (loans and securities) and funding (deposits and borrowings), the composition of both sides of the balance sheet is important to the impact on the income statement and, ultimately, its valuation. For banks that derive a large portion of revenue from net interest income (interest income on assets minus funding costs), a rate increase will generally be positive as loan yields tied directly to the federal-funds rate will rise immediately. But, the positive interest income impact depends upon the composition of assets at the bank. For example, we expect that credit card loans and any other variable-rate loan tied to the federal-funds rate will also increase either immediately or upon the next repricing deadline, usually within one year. On the other hand, any fixed-rate mortgage or commercial real estate loan would not reprice until maturity. Banks with a larger mix of fixed-rate loans are likely to benefit from net interest margin expansion eventually, albeit at a slower pace compared with lenders more highly exposed to variable-rate loans.
The other major asset class held by banks is securities, generally government-issued bonds or mortgage-backed securities. During this period of low interest rates, most banks have kept durations (the weighted average time cash flows are received) on their securities portfolios as short as possible in anticipation of FOMC rate increases. Most banks have structured their securities portfolios with shorter-term, lower-yielding securities that can be reinvested at new higher yields upon maturity. With nearly every bank keeping securities' duration short over the last few years in anticipation of FOMC increases, we do not think any one bank will have a meaningful advantage in realizing higher spreads in its securities portfolio than any other bank.
On the other side of the banks' balance sheets is the bigger question that analysts and investors have tried to grasp, which is the impact on funding with higher rates. Again, we think it depends on the composition of funding for the individual bank. For institutions with loan/deposit ratios below 90%, we generally think higher interest rates will not have an immediate effect on funding costs. Much like the asset side, it will take time for funding to move out of the bank or to higher-yielding deposit products. We think banks with moats tied to funding costs or cost advantages will have more control over their costs because they will typically have a larger level of non-interest-bearing or demand deposits than competitors. That is, banks with non-interest-bearing deposits totaling more than 25% of total deposits will realize slower funding cost growth than those with fewer demand deposits. Banks with higher levels of demand deposits usually acquired those deposits from commercial or business customers. Businesses keep demand deposits on hand with the bank to gain more favorable terms on other bank products or to keep for future investment into their own business. If the banks' demand deposits are commercially derived, we think there will be little outflow to other uses for the cash or investment in other liquid assets.
For banks with high loan/deposit ratios with few options to replace funding, we think higher interest rates are a negative, as deposit funding would probably seek the highest yield, either at the current institution or elsewhere. For banks with lower levels of demand deposits relative to overall funding or for retail/consumer-derived demand deposits, we would expect some outflows of those no-cost deposits for which the bank will either encourage the customer to keep deposits at the bank with an interest-bearing product or replace the funding with higher-cost borrowings. Either way, it will increase the funding costs for the bank.
We point investors to U.S. Bancorp (USB), with its superior funding mix resulting from its high level of commercial demand deposit keeping funding costs in check. We also like Toronto-Dominion Bank (TD) with its large presence in the U.S. Northeast and growing commercial loans that we expect to reprice relatively quickly compared with the rest of the portfolio.
Not all banks rely on the spread between lending and funding costs. Some banks are focused on asset custody and servicing as a business with its naturally sticky customers who are loath to risk changing providers. As such, it is a naturally high-return and highly scalable business. Despite these advantages, revenue growth has been a challenge in recent years as a result of persistently low interest rates and increasing client attention on fee levels. While custody banks do not make significant amounts of loans, they do take in low-cost deposits from customers and invest them in high-quality securities; near-zero interest rates have weighed on these securities' yields and depressed revenue. Moreover, most custody banks also operate asset managers and offer money market funds to their customers. Ultralow rates have meant that returns on these funds are below typical fee levels, which has forced custody banks (like other asset managers) to waive hundreds of millions of dollars of fee revenue. While a rate increase alleviates some of the pressure to waive fees, we think further rate increases will be needed for the asset managers to fully reimplement the fees.
All of the custody banks we cover have the scale and scope necessary to serve institutional clients, which few competitors can hope to match, and we expect all of them to benefit from an increase in interest rates. We currently see State Street (STT) as the most attractively priced, with BNY Mellon (BK) also trading at a discount to our fair value estimate. We expect fee levels to stabilize as the economic environment improves and investors will see the benefit of the business' operating leverage as net interest margins eventually normalize.
Brokerages and Investment Banks
Retail brokerages are highly leveraged to rising interest rates. The effect of rising interest rates on money market fund fee waivers, net interest margins, and operating leverage is the key contributor to our projection of a more than doubling of operating income for wide-moat Charles Schwab (SCHW) and narrow-moat TD Ameritrade (AMTD) over the next five years. While Charles Schwab will receive a greater benefit from rising short-term rates due to its $600 million-plus of money market fund fee waivers that will cease with the first 100-basis-point increase in the fed-funds rate, 40%-50% of TD Ameritrade's interest-earning assets are also tied to short-term rates, and we believe that TD Ameritrade is currently trading at a more attractive valuation.
Most investment banks should only modestly benefit from rising interest rates. As interest rates are rising from a very low base, we don't believe they will have a material effect on underwriting or merger activity. In terms of trading, rising interest rates should only have a temporary effect if they increase market volatility. The investment banks that are most affected by higher rates are the ones with material wealth management operations, such as narrow-moat Morgan Stanley (MS), as the net interest margin on their client cash balances should expand.
Life insurance companies should benefit from a fed-funds increase in two ways. First, with benefit liabilities that they carry on their books spanning 30-50 years, life insurance companies are particularly sensitive to long-term rates. The behavior of the firm's liabilities is similar to that of a long bond, where a small change in interest rates can have a magnified effect on the balance sheet through a change in the fair value of the liabilities. An increase in interest rates leads to a decline in fair value of liabilities in the form of reserves releases, which are added to earnings. Second, life insurance companies generally benefit from higher investment income driven by rate increases. The net benefit is typically smaller, however, because the increase in investment income is partially offset by unrealized losses on fixed-income assets in the investment portfolio. Overall, we view life insurers as highly leveraged to any increases in interest rates.
MetLife (MET) is our top pick in terms of benefiting from a rate increase. Since the end of the last financial crisis, MetLife has worked hard to derisk and simplify its insurance and annuity products, with the intention of leveraging the firm to a rise in interest rates. MetLife's positioning on rates is structured as a short position in complex products such as universal life and variable annuity and a long position in simpler rate-sensitive products such as whole life and fixed annuity. With this setup, we expect the company to earn better returns on a steady stream of premiums while getting periodic reserve releases to help boost earnings.
For traditional asset managers, a rising interest rate environment is a mixed bag. For firms that offer money market funds to investors, rising interest rates are a positive. For much of the past eight years, fund companies offering government agency and Treasury funds have had to waive fees because historically low interest rates have left yields after expenses in negative territory. The general consensus is that once the federal-funds rate gets up to 100 basis points, it will eliminate the need for most fee waivers. That said, we're not entirely convinced that money market fee rates will return to the levels seen before the 2008-09 financial crisis, when cash management funds were generating fees of 27 basis points; we believe we'll probably see rates closer to 20 basis points (if not lower) as institutional clients push back on fee rate increases.
For the asset managers as a group, a rising interest rate environment is a net negative for firms running fixed-income strategies. Those managers will have to deal with the potential impact of market losses on bond portfolios (as interest rates rise) and outflows (as investors respond to bond fund losses). That said, we expect the market losses to be more of a problem than the outflows--especially for the more institutional focused managers like BlackRock (BLK) and Legg Mason (LM) (with most institutional investors having already reallocated their exposure to the asset class to accommodate a rising interest rate environment). Firms with heavier retail exposure are likely to see the combined impact of market losses and outflows, but with most of these companies having have less than 25% of their total assets under management dedicated to the asset class, the impact is lessened somewhat.
Dan Werner does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.