To say the last few weeks have been unkind to financials is, well, a gross understatement. The outright beating most bank and financial stocks have taken since the end of December has really been a sight to behold and has also created some real bargains in the space if you believe the world is not ending. I think the Fed is at the core of the selloff in financials because it made such a big deal of raising short term rates for the first time in almost a decade that it was cornered and had no choice. I presented some data in December that argued the Fed shouldn't have raised rates but did anyway and since that bump in short term rates, it has been Armageddon for the financials. In particular, the most interest-rate sensitive of the TBTF bunch - Bank of America (NYSE:BAC) - has been absolutely crushed, falling from more than $17 to under $13 in a matter of weeks. This kind of brutal selloff is no doubt due to the uncertainty the Fed has created as it has mismanaged (my opinion) its first rate hike since before the financial crisis hit. But what has really happened to rates since the December hike and why are bank investors so pessimistic?
This two month chart of BAC shows just how bad the carnage has been. A stock that was flying based upon the prospect of higher rates has been beaten into submission and then some, hitting multi-year lows in the process. The story is the same across most financials but the magnitudes differ; certain banks that are deemed more sensitive to rates have been trounced while others have fared somewhat better, although only in a relative sense. The bull case for BAC begins and ends with the story of rates and since I have been guilty of being long BAC during this rough time period, I think examining the actual yield curve and its implications on BAC's earning potential for 2016 is instructive.
I said back in December that bonds were telling us that inflation wasn't coming; Treasury bonds are the best indicator of forward inflation because real people are putting real money on the line. I don't care what the Fed's dot plot says or anyone else's forecasts for that matter; what matters is the market and even back in December, the bond market was saying inflation wasn't coming. So what has happened to yields since the Fed hiked? I pulled down this chart of the yield curve from the Treasury's data center that shows rates on 12/15/15 - the date of the December FOMC meeting - and yesterday's close in the bond market. What it shows is fascinating and it also - I believe - shows that the damage that has been done to BAC and other financials is way overblown.
What we see here is that short term yields have moved up very slightly - the green line for January is above the blue line for December at the short end - but that for the 6 month and over part of the yield curve, rates have moved down. This isn't unexpected considering the evidence for long term inflation just doesn't exist so Treasuries are trading as such on the long end of the curve. But of course, this kind of flattening of the yield curve is certainly undesirable as banks have their costs at the short end and their revenue at the higher end, generally speaking. So we know the yield curve is flattening, but what does that mean for earnings?
Here's where I think it gets interesting for BAC; the company's earnings are certainly dependent upon the company's ability to borrow short and lend long just like any other bank but the move in terms of its costs and yields hasn't been that huge. The move in the stock has been far larger than the actual move in the yield curve, suggesting that investors think the Fed is going to carry on with its projected four hikes in 2016. If the Fed continues to hike and do so four times this year - bringing the Fed Funds rate to approximately 1.5% - the yield curve will probably be much flatter than it is now. That would certainly be disastrous for BAC and other banks that are dependent upon rates the way BAC is but in order to believe the current $13 price is the right price, you have to believe the Fed is going to hike four times this year. Otherwise, the yield curve hasn't flattened nearly enough to justify the ~25% selloff we've seen in just the past few weeks. BAC's earnings aren't that sensitive to rates because if they were, its earnings certainly would have moved around much more than they have in the past few years. Of course that isn't the case but the way it is being priced right now, you'd think BAC needs a spread of 4% between the long and short end of the yield curve; it's just ludicrous.
I'm not trying to sugar coat the current situation with rates because the yield curve has certainly flattened in the past month or so. Short term rates are up slightly and longer term rates have moved down ~25bps or so depending upon which maturity you look at. That is not an insignificant move but it also isn't disastrous. Someone who hasn't been watching the markets and just saw a chart of BAC's stock may think the Fed hiked four times in December alone; the stock's reaction has been highly unreasonable. I get that BAC is more rate-sensitive than other TBTFs but the move has been overly exaggerated to be sure.
In order to believe $13 is the correct valuation for BAC right now, you have to believe the Fed is going to hike a few times in 2016. You'd be forgiven for thinking such a thing; the Fed continues to say that it will keep to its schedule. However, I have to think the reaction from the stock market matters to the FOMC - it has in the past - and the fact that inflation is still nowhere to be found makes me think the Fed will back off of its four hike target for 2016. The January meeting that begins today will be very telling in terms of the commentary that comes out of it; the Fed wouldn't dare hike tomorrow considering what has happened since it did so the first time. I think we'll get a dovish statement that may be the first step towards putting the market at ease about the pace of rate hikes because right now, there is tremendous uncertainty surrounding the pace of future hikes. If the Fed backs off of its pace of hikes this year, we should see a relief rally in the financials and since BAC is the most rate-sensitive of the TBTFs, it stands to benefit the most.
I don't see a reasonable scenario where BAC should trade for $13 right now because that kind of valuation suggests that it is pricing in a few rate hikes that haven't even happened yet. If the FOMC sticks to its four hikes this year things are likely to get rough for BAC in terms of earnings growth. But even still, the yield curve hasn't moved nearly enough to justify the move to $13. This situation has created an opportunity where the financials are pricing in lots of bad news that hasn't happened - and may not happen at all - such that the risk/reward is heavily skewed towards the bulls. Owning bank stocks in this environment is certainly not for the weak but putting new money to work in BAC at $13 is a tremendous opportunity to own BAC at multi-year lows despite the fact that it is exhibiting such strong earnings growth potential. The Fed has made investing in bank stocks very difficult but at $13, I'll certainly take my chances that the FOMC will back off of its four hike forecast for 2016 and if it does, we should see a powerful relief rally in BAC and the other financials.
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.