Bank Of America Banking On 2 Rate Hikes

| About: Bank of (BAC)


BAC sold off on renewed expectations of lower for longer rates.

But the Fed has backed itself into a corner much the same way that it did last December.

I believe the market's expectation for just one hike this year is wrong simply because the Fed needs to save face and maintain its credibility.

Market participants continue to hang on every word that Fed officials utter these days as we are certainly at a crossroads in not only the stock market, but virtually every other asset class as well. The Fed has had a very rough time trying to remove the unprecedented accommodation it has thrust upon the markets since the financial crisis several years ago and that uncertainty has led to some significant volatility across the spectrum of financial assets. This list certainly includes bank stocks and perhaps more than any other group, the banks have been impacted by the uncertainty caused by the Fed's comments of late.

I appreciate the unbelievably difficult task the Fed has in managing the US economy and to a certain extent, the global economy as no other governing body in the world has as much power. That job is very difficult and often leads to situations where there is no "right" answer and I think we've found ourselves in just such a spot. The Fed raised rates back in December despite the fact that overwhelming evidence suggested that it shouldn't. What resulted was, of course, a very sharp bear market in bank stocks in general and one of the hardest hit was Bank of America (NYSE:BAC). BAC's balance sheet has been built to take advantage of higher rates so when those rates have failed to materialize, the stock has been hammered.

Indeed, this is the case after Chair Yellen's widely followed speech Tuesday afternoon as the Chair's comments sent buyers out in full force for stocks, gold and Treasuries. One thing that buyers did not pick up, however, were bank stocks as BAC fell 1.5% on the day. The reason for the sell-off (again) in BAC was Yellen's remarks regarding future rate hikes, remarks that in some ways, directly contrast what the FOMC has said in the recent past.

The thing about the newest version of the FOMC is that its members are free to openly discuss their personal views in the public. We see this many times per month as FOMC members routinely give speeches that agree or disagree with the "house view" of the FOMC. This unparalleled amount of transparency gives us a glimpse into individual members' thoughts but when those thoughts contradict each other, it can create confusion. Indeed, when the Chair herself seemingly contradicts what the group is saying, it can create a situation where investors don't know what the Fed is going to do. The FOMC seemed very sure of itself in offering the two hike guidance for this year but Yellen's comments now suggest that there is no real cadence on the table for rate hikes.

We find ourselves there now as the Fed's March policy statement reversed its freshly minted guidance for four rate hikes this year and halved it down to just two. However, the market still continues to expect there is just a 19% chance that the Fed will make good on its promise to raise rates twice this year, down from 26% yesterday before the Chair's remarks were made. What's interesting is that bank stocks like BAC are trading on the market's expectations but I believe the Fed has backed itself into a corner where it has to raise rates twice this year to save face, the same sort of situation that led to the ill-advised December rate hike.

The thinking goes like this: perhaps the most powerful policy tool the Fed has is its credibility. No other institution in the world can move markets like the Fed with the simple power of words. Indeed, the FOMC has proven time and again over the past several years that it doesn't necessarily have to actually do anything as long as the markets know where it stands and that it may act if needed. That credibility is perhaps more important than any policy tools the Fed could use to influence the economy. With the Fed having hiked in December due to this, I think we'll see the Fed hike twice this year regardless of what the data says because it has to; guidance has already been halved after only a couple of months and if the Fed backs off of its guidance again, no one will believe what the FOMC says anymore. The Fed simply cannot afford to lose credibility and acknowledging that it simply has no idea what its forward guidance should be again is unforgivable.

In December I made the case that the Fed would hike despite the fact that all of the FOMC's stated metrics said that it shouldn't and of course, it did. That was to save face after the Fed had built up the expectation to the market that it would hike in December so it really didn't matter what the data said. Now, with the Fed having stated it will hike twice this year in its revised guidance, I believe it has no choice but to follow through. That may mean the last two meetings of the year produce hikes or it may mean one hike this summer and one this fall; the timing is still up in the air. But one thing I'm certain of is that the Fed's waning credibility with market participants is something it wants to nip in the bud right now before it deteriorates further because as I said, the Fed has to maintain its credibility with markets or it will become far less effective at managing our economy.

So what does this mean for BAC? The stock has been trading on the expectations of the market that the Fed will only hike once this year and as we can see, Treasuries are doing the same. There are many ways to look at rates and their impacts on banks but for simplicity's sake, we'll use the 2/10 US Treasury spread as an example.

Note: this chart is from the St. Louis Fed's FRED tool.

Click to enlarge

We can see the spread has been hammered since the summer of last year, right around the time the Fed began preparing markets for its first hike in December of 2015. However, instead of the spread stabilizing or widening as one may expect as the Fed begins to remove accommodation, it has continued to tighten as market participants are betting the Fed won't follow through with its guidance. Indeed, the spread is hovering around just 1% now after falling sharply again yesterday on the Chair's remarks. Here's the opportunity though; with BAC falling due to (once again) lower expectations for rate hikes this year, shares are too cheap if you think the Fed will follow through.

I maintain that the Fed will hike twice this year not because it is the right thing to do, but because it has to. The Fed cannot afford to come back to the market, hat in hand once again and tell all of us that its forecast is no good. The two rate hike cadence was chosen very carefully earlier this year and it would take a monumental derailment of the economy for the Fed to back off of it now. That simply isn't going to happen as the economy continues to produce low unemployment and core inflation near the Fed's stated target. In short, I think the market is wrong and that the Fed will indeed hike twice.

What that means for BAC is that when it becomes clear that the Fed intends to hike twice later this year, the bank stocks should rally. BAC has the most leverage among the big banks to rising rates so it stands to gain the most just as it has stood to lose the most as rates have moved down. In addition, with the yield curve as flat as it has been in years, banks right now are very out of favor. If the yield curve steepens or even just stabilizes, BAC stands to benefit from a relief rally if nothing else. Of course, if the Fed does once again change its forecast for rate hikes, all bets are off and the bank stocks will likely get crushed again. I just don't think the Fed can allow that to happen again.

With as much respect as I have for Chair Yellen and the difficult task before the FOMC in terms of managing the removal of accommodation, I think the confusion caused by sometimes conflicting rhetoric has created an opportunity in the bank stocks, namely Bank of America as my favorite choice. BAC certainly has the most leverage to rate hikes among the big banks and while that has been a curse for the last several years, it will be a blessing when the Fed makes good on its promise to hike rates twice. And with the market expecting just one hike, that upside surprise stands to benefit BAC immensely. Owning BAC has been painful of late but given the markets newly lowered expectations for rate hikes this year, I think we have seen the bottom in terms of the flatness of the yield curve and that is great news for BAC and the bank stocks to stage a relief rally.

Disclosure: I am/we are long BAC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.