The Fed To Drive Bank Of America, Citigroup, JPMorgan And Financials Higher

Summary

• Historically, as yields have risen, so too have bank stocks.
• We're already seeing moves higher in financials as a result of anticipation of a Fed rate hike.
• However, it's the balance sheet reduction that'll likely drive banks higher in the medium to long-term.

With the Fed meeting this week, a rate hike is not likely, but the economic outlook, the dot plot, and any Fed speak on the timeline for reducing the Fed's massive $4.5 trillion should be important in determining the medium to long-term moves in bank stocks. Following the meeting, the Fed will release their updated economic projections and should provide insight as to the central bank's next steps.

We're starting to see the market anticipate a taper, albeit a gradual taper as the 10-year yield has begun to nudge higher again.

The 10-year yield and bank stocks:

The 10-year yield is jumping higher on the back of expectations of Fed hikes and a balance sheet reduction. If anyone wanted proof that Fed action can impact the yield curve, the chart below will help clarify the correlation.

Although the 10-year is typically driven by long-term economic growth and inflation expectations, a bullish view of the economy by the Fed should translate into a higher Fed funds rate and a Fed taper. In other words, if the Fed is hiking and tapering, it means that Fed policy makers believe the economy is likely to grow in the medium to long-term.

Since higher growth leads to more lending and typically higher yields, bank stocks will likely be the biggest winners going into next year.

Currently, the anticipation of a Fed taper has already begun to move banks higher. Bank of America Corporation (NYSE:BAC) is up over 8%, JPMorgan Chase & Co. (NYSE:JPM) is up over 5.5% and Citigroup Inc. (NYSE:C) almost 8% since September 7th. Even Wells Fargo Corporation (WFC) bounced back by (+7%) in the past two weeks despite the negative press surrounding the ongoing sales scandal.

If we're seeing these type of gains in bank stocks today with the 10-year yield at 2.2% and economic growth at 3% (Q2), what will the percentage gains be if the 10-year is back to 2.5-2.7% or economic growth at 3.5-4% in 2018?

10 Year Treasury Rate data by YCharts

Bank stocks have been resilient

Overall, bank stocks have held up fairly well given how low yields have been over the past year. In my opinion, the resiliency of bank stocks means that the bulls are in control despite the 10-year yield falling to 2%. In other words, sellers did not gain control of the market and drive bank stocks lower into correction territory. As a result, a rise in yields should have a much bigger impact on the stocks, since sellers are not prevalent in the current market.

If the Fed begins its tapering of the balance sheet, the banking industry should win out throughout 2018. Of course, that's not to say there won't be pullbacks and retracements, but the overall long-term trend is bullish as long as economic growth and yields rise in tandem.

Risks to banks following the Fed meeting:

Inflation expectations could stall Fed hikes:

The Fed's favorite inflation monitor is the PCE which measures input prices (costs) that go into producing goods and services in the economy. If inflation remains below the Fed's 2% target, there may not be enough impetus to hike for a third time this year or aggressively in 2018. Although, in my opinion, the Fed would continue to hike, perhaps at a more gradual pace. In short, we'll see fewer rate hikes in 2018 if inflation remains markedly below 2%.

Following the Fed meeting, watch for any hints of the inflation expectations on the Fed's graph below to be lowered since it'll likely increase the dovishness of policy makers for 2018.

Chart from federalreserve.gov

What does the dot plot mean for the Fed's expectations of growth?

Here's how the Fed sees the dot plot as a measure of growth in the economy.

"This chart (dot plot) is based on policymakers' assessments of appropriate monetary policy, which, by definition, is the future path of policy that each participant deems most likely to foster outcomes for economic activity and inflation that best satisfy his or her interpretation of the Federal Reserve's dual objectives of maximum employment and stable prices." - Federalreserve.gov

• The current dot plot before this week's meeting (below) shows that the long-term Fed funds is expected to be at around 3% by next year. If we see any dialing back of the long-term dots to a 2.7% for example, this might limit yield spikes in the short-term.
• In my opinion, if inflation remains subdued, we could have a scenario where the Fed lowers the dot plot, thus hiking fewer times in 2018, however, remaining bullish on the economy. This is somewhat counter to normal Fed policy. If the Fed hikes fewer times, doesn't that mean they're less bullish on the economy?
• The answer lies in the fact that the Fed can boost yields by another means, balance sheet reduction. The result would be fewer rate hikes with a systematic gradual reduction in the balance sheet. Oddly enough, the balance sheet taper may lead to a dovish Fed by keeping the Fed funds at low levels. In other words, the Fed may not feel the need to hike rates as aggressively since Yellen and company might see tapering as tightening monetary conditions since a taper removes liquidity from the bond market.
• As a result, we may see some confusion in the market in the coming weeks until the balance sheet reduction program has begun and there's a clearly defined amount that'll be reduced on a monthly or quarterly basis.
• However, the Fed funds rate typically drives short-term rates like the 2-year Treasury yield, but the long-term yields (the 10-year yield) will likely be driven by growth expectations and the Fed's balance sheet reduction. As a result, as long as the Fed sees economic growth rising, banks should do well since it should translate to balance sheet reductions. The Fed's plans for hiking short-term rates may become less of a market-mover as we proceed into 2018.

Graph from the federalreserve.gov.

The good news for bank stocks lies in the Fed's growth expectations:

• The Fed currently expects the U.S. to grow at an anemic 2.1% in 2018. Since Q2 of this year was revised higher to 3%, the chances of their expectations being below actual results are quite good.
• In other words, expect the Fed in the next couple of meetings to revise their growth estimates higher.
• A revision to higher economic growth estimates by the Fed should send a signal to the market that tighter monetary policy is all but certain in 2018, through some combination of balance sheet reductions and Fed hikes.
• Any revision in growth to the upside should be seen by the market as the Fed's bullish on the economy, resulting in bullishness for the 10-year yield (through a bond market selloff), and bullishness for financials.

Graph from the federalreserve.gov.

Takeaways and what to watch for:

• We may see a divergence of sorts in the bond market whereby the Fed might signal fewer rate hikes impacting the short-term yields but simultaneously speak of balance sheet reductions which should bolster long-term yields.
• Watch for any hints that the Fed expects inflation to rise or fall as that will impact their plans for hiking the Fed funds rate.
• Also, watch for growth expectations going into next year because these expectations will help shape the aggressiveness of the balance sheet reductions and the number of rate hikes.
• And of course, watch GDP growth in the U.S. for Q3 and Q4 as the strength of the economy will drive the 10-year yield as the market should anticipate more Fed action as a result of stronger growth.
• Also, watch for global growth in China and Europe since it'll give the Fed fewer reasons to pause. For example, I believe Germany is a very attractive market right now. Since the last time I checked in on the economy, it looked to me that things are shaping up quite nicely for the end of this year and going into 2018. As a result, if there's growth in Europe, the ECB will more likely taper and it would be hard for the Fed to not do the same.

All in all, the banking industry is poised to be well supported going into 2018, I believe. The balance sheet reductions should be well on their way by then and we should have had a couple of quarters of nearly 3% GDP growth under our belts.

Stay tuned for more as I'll update the forecast following the Fed meeting and the release of their economic projections. And don't forget to become a follower to receive email alerts (see below).

Good luck out there.

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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.