The Fed's bond buying spree is the largest central bank action ever. Its reversal, and eventual exit, will be even bigger.
Recent data point to the fact that the Fed can and should slow or cease its purchases of Treasury and mortgage-backed securities.
America's shrinking deficit
Believe it or not, the monstrous American deficit of 2009 is no more. In the 2013 fiscal year, the deficit will shrink to 4% of GDP according to the Congressional Budget Office. That's down from 10.2% in 2009 and 7% just last year.
To be fair, the government has some help. Interest paid to the Fed from U.S. Treasury bonds and MBS investments is returned to the U.S. Treasury. The Fed returned $91 billion to American coffers in 2012. After making $85 billion bond buys each month in 2013, the Fed's payments to the U.S. government will only grow larger for this year.
Meanwhile, the GSEs, Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are in the conservatorship of Washington, D.C. After rewriting the rules to steal the GSEs from equity holders in 2012, all cash flows from Fannie and Freddie go straight to government. The GSEs wrote checks totaling more than $66 billion just this year.
Either way you slice it, the shrinking deficit enables the Fed to think seriously about an end to the taper. Arguably, rising rates may be marginally more impactful to employment given that many more people are willing to retire at interest rates of 5-6% rather than rates of 0%.
Smart moves to make
The Fed's taper has direct and indirect consequences. An end to easy money will reduce liquidity for the riskiest of assets, which is why junk bonds have been a poor performer since rates ticked up in May. Indirectly, an end to quantitative easing will increase the cost of capital - interest rates are going higher.
In 2012 I laid the case that bank stock ETFs would continue their 2012 rally into 2013 based on rising net interest margin and new loan volume. They have - year-to-date returns sit at 29% for investors in thePowerShares KBW Bank Portfolio ETF (NASDAQ:KBWB).
Rising rates are generally good for the banking sector, with a few exceptions. Mortgage leaders including JPMorgan (NYSE:JPM) and Wells Fargo (NYSE:WFC) generate substantial income from mortgage origination. As rates rise, the easy money in writing new loans to sell to Fannie and Freddie will fall off.
However, traditional retail banking will become more profitable. Banks will earn higher spreads on commercial loans, automotive loans, and eventually the spread between interest paid and earned on savings account balances will widen (or just turn positive altogether).
The makeup of the PowerShares KBW Bank Portfolio ETF makes it very attractive. Smaller banks (regional banks) are a small part of the total fund. Their shares have rocketed well above book value due to their simplicity.
Investors still shocked by 2008 and 2009 have turned away from the larger banking institutions, which engage in more speculative and risky banking practices. That money moved to smaller, easier to understand regional banks. So there's a valuation difference between your average small bank and your average big bank.
On average, the banking sector trades at just 1.04 times book when you buy it through the KBWB ETF. With returns on equity coming in at 8.6%, investors can expect effective returns of 8.6% plus growth on new deposits and lending volume. Add GDP growth of 1.7-2.5% and you get a baseline, 10% effective return.
The SPDR Regional Bank ETF (NYSEARCA:KBE) trades at a 37% premium to book value, although ROE is higher at 9.8%.
Growth is the play here. When a bank trades above book value, it can no longer create easy value by purchasing its own shares. Instead, it must redeploy capital in lending. Regional banks owned the competitive landscape when shares of major banking firms sold for below book. However, now that the industry trades at or above book value, larger banks have the scale advantages to price smaller institutions out of the market. The KBWB ETF weights heavily the largest banks.
Making the taper pay off
Cashing in with the taper is as easy as wagering on the companies that make money on their float - insurance companies, banks, and even payroll companies like Automatic Data Processing (NASDAQ:ADP).
Investors have been too quick to assume that an end to quantitative easing is an end to bull markets. It may take a bite out of some sectors - think construction or car sales - but it will buoy the companies that make money on higher rates.
All in, the banking industry makes for an exceptional wager at any price at or around book. Should investors become comfortable again with the larger banking institutions, the KBWB ETF will be one of the largest beneficiaries of higher valuations. In the meantime, you get paid to wait and can ignore all things "taper."
Disclosure: No position in any ticker mentioned here.