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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.

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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.

Dan Werner does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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