The Fed Hikes Rates Ahead Of Upcoming Financial Sector Earnings

After the 2007-2008 financial crisis, central banks around the world took extraordinary measures with monetary policy to spur economic growth and provide stability in global markets.

Things have been slowly moving the other way and the Fed has picked up the pace of rate hikes since the start of 2017. On Wednesday this week, the FOMC raised the Fed funds rate by a quarter-point to 1.5%-1.75%, its first hike of 2018 after three hikes last year.

The median projection for rates by 2020 was 3.4%, according to the Fed’s “dot plot”. Keep in mind a lot could happen between now and 2020. As Fed Chair Powell put it during Wednesday’s press conference, the projection is “highly uncertain”.   

Low interest rates had weighed on bank profits because they were earning lower interest on their cash and the rates at which they could lend to consumers for mortgages and other loans was also lower. Now that interest rates have been ticking higher, banks can earn more on their cash reserves and generate greater profits on loans as long as the yield curve, the difference between short and long-term rates, doesn’t flatten significantly.

With low volatility throughout 2017, trading revenues have also been pressured at many of the major banks and CEOs were regularly warning of double-digit drops ahead of earnings. Volatility came roaring back in 2018, and a couple of banks have commented that their trading desks were significantly busier in Q1.

For Q1 2018, the financial sector is expected to report 20% year-over-year earnings growth, the fourth highest out of all the sectors in the S&P 500 (SPX), according to FactSet. Revenue is expected to increase 7.4% year over year, also the fourth highest out of the SPX sectors. 

FINANCIAL SECTOR SINCE START OF 2018. Since the start of 2018, S&P Financial Select Sector Index (IXM, orange line) has outperformed the S&P 500 (SPX, teal line) and the Dow Jones Industrial Average ($DJI, purple line). Year-to-date returns as a percentage are shown on the right hand side of the chart. Chart source: thinkorswim® by TD Ameritrade.  Not a recommendation. For illustrative purposes only. Past performance does not guarantee future results.

Interest Rates and Economic Growth

As the Fed has continued on the path of tightening, many analysts see rising interest rates as a tailwind for financial institutions as long as they don’t rise too fast or the yield curve doesn’t flatten too much.

At the same time, ongoing global growth across most of the world, with the exception of a small number of countries, has helped the financial sector as well. When the economy is stronger, companies are typically expanding, investing in their businesses, raising capital, etc. Weaker consumer spending recently in the U.S. has resulted in a few analysts cutting back their expectations for GDP growth, but many other economic indicators have remained strong.

Regulatory Rollback

Congress has been in the process of trying to tweak Dodd-Frank for some time. The Senate passed a bill on Mar. 15 that would roll back parts of the law and loosen some of the restrictions on the financial sector, but it still needs to make it through the House.  

One of the major changes in the Senate bill is to raise the threshold of banks that are considered “systemically important” from $50 billion assets to $250 billion assets. That would eliminate all but the nation’s largest banks from the Fed’s annual stress tests, higher capital requirements and the need to submit a “living will” that details the company’s strategy if it needed to liquidate in the event of major financial distress or failure.

Some of the other changes include exempting firms with less than $10 billion in assets from the Volcker Rule, which restricts the trading activities banks can engage in, and ease lending rules for smaller and midsize banks. The House had passed a different version of their own bill in mid-2017, which still needs to be reconciled with the Senate’s version and signed by the President. So it looks like it’ll take a bit for everything to play out.

Reduced Costs and More M&A?

Some analysts expect more M&A among the smaller and mid-size banks as a byproduct of Dodd-Frank reform. In the past, smaller banks had said they were cautious about growing above $50 billion in assets to avoid the cost of additional regulations. Raising that threshold the way the Senate’s plan proposed would give them an additional $200 billion window before they faced tougher oversight.

Banks have also regularly commented on the additional costs and complexity that they incur from additional regulations, but the exact extent of those costs is hard to quantify and peg to a dollar amount. On Q1 earnings calls, the potential impact of Dodd-Frank reform will likely be a topic of discussion among some of the financial executives.

Upcoming Earnings Dates

Earnings reports from some of the biggest banks are coming up in mid-April. These are a few of the companies that have confirmed their earnings date so far:

• Wells Fargo & Co. WFC reports before market open on Friday, Apr. 13
• JPMorgan Chase & Co. JPM reports before the open on Friday, Apr. 13
• Citigroup Inc C reports before the open on Friday, Apr. 13
• Bank of America Corp BAC reports before the open on Monday, Apr. 16
• Goldman Sachs Group Inc GS reports before the open on Tuesday, Apr. 17