As you've likely already seen, the latest GDP numbers are out. And they're better than expected.
GDP rose 2.9% in the third quarter, higher than the 1.4% growth rate in the second quarter. This reading also beat expectations of just 2.5% growth and is the best number in two years. The third quarter was boosted by increased exports and a buildup of inventories, the one negative being a slower rate of increase in consumer spending.
Now the most important aspect of these GDP numbers are what they mean for December's Fed meeting. The question remains the same, will they or won't they raise?
Higher rates would be a positive for banks. And that's because most of their profits come from their net interest margin (NIM). As we've explained in a previous article:
Banks take money from depositors and pay them a low rate of interest in return. These deposits are liabilities on the bank's balance sheet. The liabilities need to be matched with assets. Assets vary from higher yielding loans (money lent out to customers), to mortgage backed securities, and even treasury bills.
The way banks make their money is on the spread between the interest paid to depositors and the yield collected on assets. This spread is called the net interest margin, or NIM for short. Without NIM, banks would not exist… it's their lifeblood.
Many thought a rate hike would be bullish for banks because it "should" increase NIM - thus boosting earnings.
This mechanism works because even though a rate hike increases both the yield on a bank's assets and the interest paid to depositors, there is normally substantial lag between the two. Banks can generally keep the deposit rate low for an extended period of time while the yield on their assets increase from raised rates. This translates into higher NIM.
So if the Fed does raise in December, it will provide a decent boost to banks. And positive econ data like these GDP numbers increases the probability that they will indeed raise.
Though it may not seem like it, the Fed is actually hawkish. They're itching to hike.
The key to remember about the Fed is that they're an academic institution. This means they're far more concerned with their own reputation than anything else. And part of their reputation comes from their credibility.
Their back and forth jawboning over the last year about rate rises was done for a reason. The goal was to keep the markets on their toes. They wanted to cool speculation while buying time to actually raise rates. But eventually, they do have to raise as they said they would. Otherwise they risk losing their credibility which is extremely important to the Fed policy of "forward guidance".
This means there's a very good chance they go ahead with a hike in December to preserve their image. It honestly wouldn't matter what type of economic data comes out from now until then. This is even more true on the off chance that Trump comes into the presidency (which the market is severely underpricing). He's known to be hostile towards the Fed with his accusations of their politically-fueled interest rate manipulation. Hiking may help keep The Donald off their back.
If you take a look at the Fed funds futures, the market is pricing in one rate hike in December as the most probable outcome (67.5%).
You can also see confirmation in this belief by looking at the STUB (consumer staples (NYSE:PG), utilities (NYSEARCA:XLU), bonds (NYSEARCA:TLT)) trade. All 3 sectors that are normally used as a flight to safety and yield have been getting hit hard as investors expect a hike to normalize rates.
In the short-term our favorite bank to go long in terms of our strategy is Citigroup. Not only is it one of the first banks to breakout, proving its strength as a leader within the higher rate theme, but it also has the lowest price-to-book value and forward price-to-earnings ratio among its peers.
The important thing to remember here is that this isn't a long-term play. Banks are rising right now because of investor expectations of higher rates and improved net interest margins. But while this may be a positive in the short term, higher rates are actually a negative for the economy as a whole and far outweigh any NIM gains.
Bridgewater wrote in a note to clients recently about the large asymmetric risks premature tightening poses to markets. They compare today to several other cases in history where tightening during deleveragings led to depressed conditions such as: the UK in 1931, the US in 1937, the UK in 1950, Japan in 2000 and 2006, and Europe in 2011.
The note went onto say:
In nearly every case, the tightening crushed the recovery, forcing the central bank to quickly reverse course and keep rates close to zero for many more years… normally, a mistake in monetary policy is not that big a deal because it can be reversed… the risk now is higher than normal because a tightening mistake is harder to reverse today when the ability to ease is more limited.
You can't expect banks to continue rising if this failed recovery scenario plays out. The negative side of rate hikes is already being expressed in the broader indices. A hike is dollar bullish and therefore a negative for equities. Small caps (NYSEARCA:IWM) have already broken lower and the S&P 500 (NYSEARCA:SPY) is close to following suit.
Broader index weakness will weigh on any long positions in the market. The best way to play this is to go long Citigroup until the $55.84 level where investors should take profits to prepare for the longer term decline.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.