What Fed's Lack of Action Means for U.S. Bank Stocks
One consequence of near-term rate stabilization is the need for banks to cut operational costs in order to increase earnings.
Last week, the Federal Reserve's Federal Open Market Committee decided to maintain the benchmark federal-funds target rate at 0.25%-0.50%, which has been consistent since its increase in December. Since that move, we have seen improvement in the net interest margins of U.S. banks as they incorporated the increase into their pricing structures. Even though the yields on loans have increased at most banks, this has not damped loan demand, which continues to be solid across our coverage, at mid-single-digit growth on average. In addition, we have observed varying degrees of net interest margin expansion among banks reporting first-quarter results, largely because of increased yields.
In December, the Fed indicated that its expected target fed-funds rate would approximate 1.375% by year-end 2016 through four subsequent increases. Since then, however, the Fed has moderated its expectation to two increases approximating 0.875% by year-end. As largely reflected in the FOMC statement, we expect future increases in the fed-funds rate to be deliberate over a longer time, with the Federal Reserve's mandate for full employment and keeping inflation at 2% continuing to dictate future moves. While the rate increase has helped loan yields for banks, the signal that another rate rise is not imminent is less welcome news for U.S. banks. Most U.S. banks remain asset-sensitive in that they are able to reprice their assets (loans and securities, for example) faster than the funding for those assets (deposits and borrowings).
Our cost of capital assumptions for all U.S. companies continues to use a 4.5% risk-free rate; thus, our bank valuations incorporate this 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.
One consequence of near-term interest rate stabilization is the need for banks to cut operational costs in order to increase earnings. One way banks do this is through branch rationalization as product delivery through mobile delivery channels continues to grow. Often, those cost cuts are used for further technology investments.
While the fed-funds rate remains at 0.25%-0.50%, FOMC members' median "longer run" (post-2018) projection is 3.25%, so we will continue to use this as a base rate for long-term asset and liability pricing. Thus, even dramatic near-term moves in the fed-funds rate would not result in meaningful changes in our bank fair value estimates. Changes in our long-term economic growth or inflation expectations for the United States continue to be more significant.
On the liability side of their balance sheets, banks have generally not had to increase their deposit rates to retain funding. We continue to believe that the cost of funding will depend 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 economic 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 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 will be more of 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 deposits 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. In addition, we like Citigroup (C) for its improved credit quality and conservative lending.
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 that 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. The short-term nature of custody banks' asset mix makes these firms especially asset sensitive. Indeed, most custody banks saw net interest margins rise about 10 basis points in the first quarter as a result of the December rate hike. 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.
Dan Werner does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.