How To Think About Rising Rates, Bank Returns And Risk

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Summary

Investors think about the trade-off between higher margins and loan losses as rates rise.

There's no real trade-off until GDP rolls over.

Growth is low but there's no recession in sight. Long banks.

As we head into the holidays, one of the main questions I am fielding is about the impact of higher interest rates on the banking sector.

The positive view is that higher rates mean higher net interest margins (NIM), while the negative view is that they will mean higher loan defaults and therefore higher charge offs and loan loss provsision (LLP) costs.

It is striking that these views are often "leveraged" in terms of their directional implication by interfacing with the promise of the Trump factor for the growth outlook and the fact that, excluding whatever Trump might do, the recent U.S. GDP growth rate has been weakening. So those people looking forward to wider NIMs are also anticipating better GDP growth, while those fearing credit defaults are also looking for weaker GDP growth.

The coherence of both the bullish and bearish narratives here gives us a hint at what might be taking place: confirmation bias - the very human tendency to look for evidence that confirms a starting belief. If you think US equities are expensive, you are more likely to emphasize weakening GDP, because trend or even strengthening GDP in the near or medium term could undermine the lofty valuations that your bubble thesis depends on. This is always why the same writers write those "never invest in banks" pieces when bank stocks are down: they see the price action as confirming their own biases and feel compelled to declare victory - very often just before the sector turns and puts in strong performance to the upside. Meanwhile, the obvious mistake for more sanguine investors here is to believe the idea that GDP can be raised dramatically without commensurate financial risk being taken and what this might do to the cost of equity in the meantime.

How to think about the NIM vs LLP tradeoff

First, a word on the macro. Forget the idea that current activity data "means" a whole lot for GDP growth in itself and ask what's causing the trend. Weak investment growth earlier this year partly had to do with the energy sector adjusting to the lower oil price and was clearly transitional, for example. And try to think in terms of trend GDP growth for your core expectations. It's quite true of course that growth in US GDP is weakening to around 1.5% real or about 3.3% nominal. See the real rate by quarter in the chart below.

However, the weakening trend in US GDP growth does not mean a recession is imminent, because 1.5% is about right for the US given the prevailing rates of population and productivity growth. So it's excessively bearish to say that we are nearing recession just because the growth rates is lower. And while the current rate of US growth has in the past presaged recessions, those episodes occurred when U.S. potential growth was higher than now, so historical comparisons are misleading. These days, 1.5% is just nominal trend growth than a portent of doom.

Likewise, while Trump's policy ideas and appointments are capital friendly (assuming he doesn't tip the U.S. into a trade war) it's by no means certain he will be able to lift GDP growth by much at all and to my mind impossible he will be able to do it sustainably without radically altering his immigration stance or an unexpected uplift in productivity occurs.

There's a handy ratio you can use to think about the NIM and LLP trade off and that's the "risk adjusted net interest margin", or "RANIM". This is simply the net interest margin calculation of net interest income divided by the average total assets or interest earning assets for the period under consideration but with LLP costs deducted from net interest income. The chart shows us this relationship for U.S. Bancorp (NYSE:USB) through 2004-2015.

Source: Company Data

The higher NIM of the pre GFC period was of course a function of higher nominal interest rates. What stands out to me in the chart is the stability of the "spread" between RANIM and NIM, which is generally a negative 30-40 bps in years where the US enjoyed growth and isn't impacted by the absolute rate of growth, which was obviously faster in the pre GFC era. I would expect USB to start providing more for LLPs especially if its loan growth picks up (the Trump factor) but for the impact of this on NIM to be about the same as now so the hope that higher rates = higher NIM and higher RANIM will bear out. What changes this is an economic downturn. This is very unlikely to come in the early years of a loan driven lift in GDP growth. I'd worry about it for 2019. This is based on the stability of the NIM-RANIM relationship in the chart above as rates peaked in 2007 and it was clearer then that leverage was overextended, which is much less the case for banks now.

Conclusion

NIM and RANIM will remain stable until US GDP rolls over seriously, and it's likely that there will be a period of higher earnings before that happens.

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.