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 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
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.
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.
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
Graph from the federalreserve.gov.
The good news for bank stocks lies in the Fed's growth expectations:
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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