Interest Rates Are Up, So Why Are Bank Stocks Down?

Rising interest rates typically represent good news for banks, who can boost their profits by lending at prevailing rates. But bank stocks have been falling this year, despite multiple interest rate hikes by the Federal Open Market Committee since March.

“The rule of thumb is that you want to own financials, and banks specifically, when rates are going up, because it is one of the few sectors that make more money with higher rates,” says Chris McGratty, head of U.S. bank research at KBW. “The real issue is the growing fear that the Fed will go too far and rates will go up to a point where it creates a recession.”

In addition, many investors priced in interest rate hikes for bank stocks before the rate hikes actually occurred, says Michael Miller, bank equity analyst at Morningstar Research.

“Bank stocks were among the strongest performers in the market throughout 2021 on the expectation of coming inflation,” Miller says. “By the end of 2021, most of the bank stocks had either fully priced or overpriced the benefits of rising interest rates.”

Banking is a cyclical sector, and economists remain split over whether the U.S. will enter a recession over the next year (or has already entered one). Gross domestic product has contracted for the last two quarters as inflation continues to affect consumers and businesses, but employment remains strong.

Looking Ahead

Although bank earnings have largely met expectations, investors are concerned that if the economy slows further and people lose their jobs, the cost of credit will increase, McGratty says.

The KBW Bank Index is down more than 30% from the start of the year, although it’s slightly up from its mid-July lows. By comparison, the S&P 500 is down 18% over the same period. (In 2021, the KBW Bank Index returned 35%, compared with a 28% return in the S&P 500.)

McGratty says that his firm is “constructive” on banks overall, and expects that smaller banks will perform even better than larger firms in the immediate future, since their revenue is more dependent on the yield curve, as higher rates and loan growth boost their revenues. Larger banks, on the other hand, are more diversified, so they have more capital markets exposure, making them more vulnerable to volatility.

“You could argue that capital markets are in a recession right now,” McGratty explains. “There’s not a lot of IPO or M&A activity. The bigger banks have underperformed in many ways because of that.”

Larger banks often also have more exposure to international markets and economies, which are facing additional economic pressures.

“The U.S. economy continues to grow and both the job market and consumer spending, and their ability to spend, remain healthy,” JPMorgan Chase & Co. CEO Jamie Dimon said in a statement upon releasing the bank’s second-quarter earnings in July. “But geopolitical tension, high inflation, waning consumer confidence, the uncertainty about how high rates have to go, and the never-before-seen quantitative tightening and their effects on global liquidity, combined with the war in Ukraine,” which he noted have a harmful effect on global energy and food prices, “are very likely to have negative consequences on the global economy sometime down the road.”

JPMorgan Chase, the largest bank in the U.S., saw profits decline 28% in the second quarter.

Other Factors

McGratty says quickly rising rates are not as helpful to banks over time, since they also have to increase the amount of interest they’re paying depositors.

“If you go back into the last rate cycle, from 2016 to 2018, once rates went up 100 to 150 basis points, people started to pay attention and the banks had to raise deposit rates, which narrowed the margin expansion narrative,” he says.

Another factor affecting banks right now is that much of the liquidity that went into the system via deposits thanks to COVID-related savings and stimulus checks is being withdrawn as savings rates start to decline. According to an analysis by Bank Reg Data, bank deposits fell nearly $370 billion in the second quarter—the largest decline in 20 years.

“The deposit outflows are creating different pressure points for some institutions,” McGratty says.