Rising rates and retail banks

Current rising rate environment

The current macro-environment has been defined by a pace of rising interest rates unseen in the U.S. for many decades. The Federal Reserve currently maintains the Federal Funds rate at a target range of 3.75%-4.00%, with the market anticipating a further rate rise, likely either a 0.50% or 0.75% hike, in December.

The rising rate environment has popped the balloon of most investors’ risk-heavy portfolios. This is because an increase in interest rates makes returns elsewhere far less achievable, thus bringing down asset prices across the board. Until inflation moderates to a manageable level, it is likely that the Federal Reserve will continue to tighten rates in order to prevent inflation from persisting. Indeed, it feels as if The Federal Reserve is willing to push the economy to the brink of a recession, even changing its rhetoric from a “soft landing” to a “hard landing” which we discuss in Hard Landing – What does this mean for markets?

How banks may benefit from rising rates?

While rising rates negatively impact most equity returns - as we have observed in the overall market with the S&P 500 down more than 15% YTD (even after its small rally in the past month) – there are some pockets that actually benefit from rising rates.

One of these pockets is within the banking sector. The primary method of generating revenue for retail banks is by borrowing money from consumers in the form of deposits, and subsequently lending it out to those who need it. This business model is heavily contingent on prevailing interest rates. While the past 10 years of near-zero interest rates have eroded retail bank interest margins, the current rising rate environment has actually provided an uplift to the profitability of most retail banks.

Now there are some risks to consider, namely that rising interest rates typically come with an increase in delinquency rates, or the probability that borrowers may default on their loans. However, this risk may be mitigated in the current environment given how tight the labor market is. As long as workers remain employed, they can continue to service their debt which will benefit retail banks all else equal. 

Examples of Bank ETFs

There are numerous bank ETFs that investors can use to gain broad-based exposure to the banking sector. Including:

KRE – SPDR S&P Regional Banking ETF

• AUM: $3.1B
• 1mo Performance: +5.8%

KBWB – Invesco KBW Bank ETF

• AUM: $2.2B
• 1mo Performance: +9.2%

IAT – iShares U.S. Regional Banks ETF

• AUM: $781M
• 1mo Performance: +8.2%

Data for this article is as of November 24, 2022.

Please note this article is for information purposes only and does not constitute investment advice.