How will banks fare amid rising rates?

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In the 15 years after the global financial crisis, the MSCI World Banks Index rose by 14%, a small fraction of the 195% in returns global stock indexes gained during the period. The difference in performance can be explained in part by the tightened regulations restricting banks’ ability to leverage their balance sheets to boost the rates of return for their shareholders. Combined with an increase in labour costs and capital reserves required to meet compliance standards, banks have had to raise their expenses, which impinged on their profitability. Falling interest rates worldwide have also been a factor that most would attribute to have impacted banks’ net interest incomes.

But would banks benefit from an increase in interest rates aimed at stamping out inflation? Before we get to the bottom of this, we think it makes sense to unpack the relationship between net interest rate spread and interest rate. According to a research report authored by economists from the Bank for International Settlements and the US Federal Reserve surveying more than 3,400 banks in 47 countries globally, a bank’s net interest rate spread will typically decrease alongside a drop in short-term interest rate (3-month Treasury bond yields). The narrowing effect on banks’ net interest rate spreads is also more evident in countries with lower interest rates than those with higher rates such that, in the former, banks’ net interest rate spreads will drop by as much as 17bp when the short-term interest rate is lowered by 1%. In the latter, however, a drop in short-term interest rate of the same degree will only reduce banks’ net interest rate spreads by 9bp. Banks in areas with higher interest rates should also have relatively higher returns on assets.

Clearly, in times of economic growth and rising interest rates, bank stocks generally make a prime investment opportunity: An increase in interest rates will widen banks’ net interest rate spreads and returns on assets, while economic growth will also stimulate demand for loans and reduce risks of bad debt – both conducive to the profitability of banks.

Having said that, despite the Fed hiking rates in the past few months, the S&P Bank ETF underperformed the broad market. This is contributed by economic uncertainties emerging across China, the US and Europe: The US, for one, saw its Q1 GDP drop by 1.4% YoY; Europe has also been confronted with recessionary pressure due to elevated natural gas prices resulting from the Russia-Ukraine conflicts; lastly, China’s battle against the pandemic will likely lead to a slowdown in consumption and export, potentially curbing its economic growth. With one of the two requisites missing, the time is perhaps yet to be ripe for banks’ outperformance.

What about the net interest rate spread in China, then? It certainly will require more than one round of regression analysis to untangle the correlation between net interest rate spreads and interest rates in China. The marketization of its interest rates only approached the final stages of completion in 2015, before which the net interest rate spreads were largely in the hands of the government, making deciphering the spread’s correlation with the rise and fall of interest rates difficult.

Only six years’ worth of data since 2016 is currently available – a dataset far from sufficiently populated from which to extract any concrete conclusion. However, when we compared China’s 3-month Treasury bond yields with the net interest rate spreads of China Construction Bank (CCB) and China Merchants Bank (CMB), some might notice what appeared to be a positive correlation where rises in interest rates led to the widening of net interest rate spreads. But such an observation would go against our analysis of changes in interest incomes and interest rates found in the annual reports of domestic banks in China: the numbers provided respectively in the 2021 annual reports of both CCB and CMB point to a decline in their net interest incomes when interest rates rose.

For investors on the prowl for specific banks that stand to benefit from interest rate rises, we think those in Hong Kong and overseas markets should be given higher priority over domestic Chinese banks. So far, the policy direction in China looks to be skewed towards lowering the interest rate, rather than increasing it; still, another uncertainty lies in exactly how a rise in interest rate, unlikely as it is, will affect the net interest rate spreads across domestic banks.

Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.

What you need to know about rate hikes

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The just-passed May meeting of the US central bank’s Federal Open Market Committee (FOMC) announced to increase the benchmark rate by a half percentage point, in line with market expectations.

Over the past two months, most discussions among investors have centred around the possibility of the US and European central banks expediting and stepping up their monetary policy tightening.

Although the answer to both questions is a resounding Yes, the European Central Bank’s (ECB) tightening schedule will lag that of the Federal Reserve owing to it bearing more brunt of the Ukraine-Russia war than the US. The ECB has also been non-committal about the rigour with which it will tighten its monetary policy due to the economic uncertainty of the region – the central bank would probably not want to get ahead of itself to give it more room for manoeuvre at a later stage.

As for the US, in view of elevated inflation and tight labour market conditions, the Fed will begin reducing the size of its balance sheet (also known as balance sheet runoff, which is the opposite of quantitative easing) while increasing the interest rate. The post-meeting statement of May showed that the Fed will begin the balance sheet runoff in June at an initial pace of $47.5 billion, stepping up over three months to $95 billion. With the Fed’s balance sheet currently standing at around $9 trillion, the process of normalisation will shrink the size of its balance sheet by as much as 13% over the coming year, a pace that surpasses the balance sheet reduction exercise that took place in 2018 – 2019 in both percentage and absolute terms.

It is expected that another half percentage rate hike will be seen in June. In fact, the March meeting detail showed that if it hadn’t been for the uncertainties brought about by the Ukraine-Russia war, it would have been a 50bp increase in the interest rate that the FOMC proceeded with in March, instead of a 25bp rise.

The FOMC estimated that the Federal funds rate will reach 1.6% – 2.4% by the end of this year – which is significantly higher than both the previous forecast of 0.6% – 0.9% and the current level of 0.3%, and may even climb to 2.4% – 3.1% by the end of next year.  

In addition to the rate hike and balance sheet runoff, the FOMC generally agreed on the gradual sales of Mortgage-Backed Security (MBS) in order to maintain a neutral stance in monetary policy without favouring any particular sector. Officials have also expressed the plan to hold primarily Treasury securities in the Fed’s portfolio.

As of now, the global markets have only seen the Fed carry out balance sheet runoff once in the past, which we think can serve as a point of reference for what is to come. Back then, the Fed began tightening with rate hikes, followed by balance sheet runoff after the Fed funds rate reached 1.25%. In contrast, the central bank is on course to trim its asset holdings much earlier in the tightening process this time.

The previous tightening cycle wrapped up after 225bp of cumulative interest rate hikes and around 15% of reduction in the Fed’s balance sheet thanks to the economy stabilising with the inflation rate settling at about 2%; any further tightening would risk putting deflationary pressure on the economy. But inflation levels today have outstripped considerably what we saw the last time around, meaning that the likelihood of deflation risk being a factor that stops the Fed from continuing to reduce its balance sheet is low. But if the central bank does take a pause in normalising its balance sheet and in increasing interest rates, it will more likely be due to a recession.

There are several aspects of balance sheet runoff and interest rate hikes this time round that warrant investors’ attention.

First, the current round of tightening measures comes in greater intensity, whereby the Fed has set out to normalise its balance sheet and lift interest rates almost simultaneously, hence broadening the associated impact on the US economy and stock market.

Second, the most curious phenomenon during the last tightening cycle was the decline in the 10-year Treasury yield, to most investors’ surprise, alongside the shrinking of the Fed’s balance sheet, when they had been forecasted to rise instead. Indeed the increase in the supply of treasury notes resulting from balance sheet runoff should push yields up, but the coexistence of the increased supply and interest rate hikes were signalling a firm determination from the Fed to tighten monetary policy, which in turn suppressed long-term inflation expectation, leading to the 10-year Treasury yield to drop. In the past two years, although the 10-year Treasury yield has largely risen, albeit not without swings, investors should pay close attention to whether the Fed’s dual-pronged tightening strategy will lead to a repeat of what took place in the last cycle.

Finally, the Fed will be selling its holdings of MBS gradually, so it’s worth noting how the current heated US real estate market will be responding to such a move.

Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.