The Federal Reserve spilled the beans… Interest rates are going up soon.
The central bank indicated last week that it plans to raise the benchmark federal funds rate from near zero as soon as March. Many analysts expect at least three rate hikes in 2022.
That sounds great for one of Wall Street’s most prized rising-rate strategies – bank stocks. After all, the common thinking is that higher rates equal higher profit potential for banks.
But as I’ll explain, you shouldn’t just blindly buy any bank stock today…
Let’s start with a hypothetical example…
We’ll assume that Big City Bank collects $1 billion in five-year certificates of deposit (CDs). Banks offer investors a higher interest rate on these products in exchange for tying up their funds over a set period of time – five years, in this case.
A year ago, the Fed hadn’t indicated to the world that it planned to raise rates three times in 2022. Because of that, Big City Bank might’ve paid 0.5% interest on five-year CDs.
At the same time, let’s say that Big City Bank charged 5% on 10-year business loans.
The 4.5-percentage-point difference is the bank’s “net interest margin.” That’s a measure of its profitability potential. It helps folks decide whether or not to invest in the bank’s stock.
Today, investors know the Fed’s plan and must look ahead…
As the benchmark interest rate rises, CD rates in the coming year will also trend higher. But at the same time, banks will be able to charge higher rates on business loans, too.
Let’s assume by this time next year, Big City Bank will offer a 1% interest rate on five-year CDs. And the bank will charge 6% on 10-year business loans. The difference is five percentage points.
In other words, with rates rising, Big City Bank’s net interest margin will be higher.
That’s the logic behind buying bank stocks when interest rates rise – like they’re expected to do in 2022. But as with most things in investing, it’s more complicated than that…
Net interest margin isn’t the only metric that matters. If it were, we’d all buy bank stocks, sit back, and watch them soar. But in short, not every bank is in position to thrive today.
Take JPMorgan Chase (JPM), for example…
Management recently warned investors that the company’s expenses are going up. Even worse, these costs of doing business will offset the benefits of a higher net interest margin.
Investors don’t want to hear bad news like that. It’s the main reason why the financial giant’s stock is down roughly 6% this year.
JPMorgan’s struggles show that investors shouldn’t just blindly buy any bank stock because interest rates are expected to rise. Always do some digging to uncover the best companies…
Regular readers know I rely on our Power Gauge for this research. It does the heavy lifting for me. It analyzes every bank stock, as well as many bank-focused exchange-traded funds.
And right now, the Power Gauge is “bullish” or better on dozens of bank stocks. For example, the outlook is bright for Wells Fargo (WFC), M&T Bank (MTB), and KeyCorp (KEY).
In the end, it’s important to keep this idea in mind as rates start rising…
Don’t just throw your money at any bank stock. Do your homework to find the best ones.
Good investing,
Marc Gerstein
