Out of all equity sectors, there is one that is positioned most precariously for an environment with rising interest rates: financials (NYSEARCA:XLF). Will higher borrowing rates discourage borrowing as much as expected? How will the big banks' bottom lines be affected? In this sector, one bank has been making headlines recently for news concerning a massive bet on rising rates. With a humble valuation, longtime heavyweight bank JPMorgan (NYSE:JPM) is the frontrunner when it comes to preparing for looming higher interest rates. Will this bet be the next 'London Whale' trade or will this result in a monumental payday to JPM shareholders?
JPMorgan CEO Jamie Dimon has seemingly been on the better side of every financial crisis since the late 1980s. With the Fed governors talking about trimming QE3 asset purchases as early as September, companies are preparing to deal with higher interest rates; JPMorgan is at the forefront of this movement. Dimon has expressed his views on the uncertainty of the future interest rate environment by explaining in his annual letter the possibility of "significant negative consequences" on the bank's revenues attributed to rising interest rates. He also feels responsible to protect the bank from these consequences by stating:
We cannot ignore this possibility and must safeguard against unintended and adverse outcomes.
Addressing this uncertainty from a risk management perspective is a nightmare, but JPMorgan has formulated a plan of attack.
So what is Jamie Dimon doing to protect his bank and shareholders from the prospective damage of rising interest rates? Dimon claimed in the same letter to shareholders that:
As we currently are positioned, if rates went up 300 basis points (3%), our pretax profits would increase by approximately $5 billion over a one-year period.
Five billion dollars! He added that a $2 billion profit would occur over the same time period with a rise in 10-year Treasuries of 100 bp (1%). Let's put this in perspective. Below are the annual pre-tax profits (in millions) for the past five years.
This would result in an approximate 17.29% increase growth in pre-tax profits; this doesn't even include the expected profit growth. This would be a monumental boost to JPMorgan's balance sheet and would most likely offset any losses caused by higher rates in other divisions of the bank.
Although analysts are not completely sure what JPMorgan owns that would result in such profits, it is widely speculated that they are building a larger position in complex interest rate derivatives called interest rate swaps. An interest rate swap is an agreement between two parties in which one party is able to lock in future borrowing rates. JPMorgan most likely is long a substantial amount of these contracts. These securities will rise in value if rates rise, as JPMorgan is able to continue to borrow at the swap's lower rate. The higher rates rise, the more JPM will profit as the swap's value rises as the spread between the two rates widens (rates rising above agreed upon swap rate).
JPMorgan, like most financials, is still trading relatively cheap. Below is a look into the valuation of JPM (trailing 12 months).
Compared to an industry standard P/E of 15.75 and P/B value of 1.50, JPMorgan seems to be cheaply valued to its peers. Also, Jamie Dimon is debatably the best CEO on Wall Street. The leadership and management at JPM are simply top quality. JPMorgan appears convinced rates will rise in the near future. Dimon reiterated this point at the Morgan Stanley financial services conference by declaring that "rates are going to go up". In addition, a position of this magnitude is quite a sign of conviction in this belief. In conclusion, there are numerous ways to play rising interest rates, but buying a financial stock that is confidently positioned to profit from rising rates may be the best way to gain exposure. Being long JPM would also limit the risk that revenue growth in the financial sector will stall in a higher rate environment. Finally, buying this stock is a great risk-reward scenario in the face of a higher likelihood of the Fed pulling back asset purchases due to the stock's valuation, spectacular leadership, and dividend yield.