BANK BULLS CAUTIOUS OF POLICY SHIFTS

Changing dynamic in bond market amid Fed rate moves starting to give pause to some stock rallies

BANK shares have been the runaway winners of the post-election United States stock market boom as investors wagered that higher interest rates, lighter regulation, lower taxes and faster economic growth would boost profits for lenders.

Up 32 per cent since the election of Donald Trump, the Standard & Poor’s 500 bank index has outpaced the wider market’s gain by roughly 3-to-1.

Now, however, a changing dynamic in the bond market as the US Federal Reserve gears up to raise interest rates at a faster pace than many had previously expected is beginning to give pause to some early bank stock bulls.

With another strong US jobs report in the books, the Fed is widely expected to raise overnight interest rates on Wednesday, and is now seen delivering three rate hikes this year.

Rising rates can boost bank profits, but bank profitability also hinges on the difference between shortterm rates, like those set by the Fed and which tend to mark the cost for banks to acquire their funds, and long-term rates, which serve as benchmarks for what banks charge their customers for loans.

When that difference, or spread, is large, bank profits can rise rapidly. When it narrows, or flattens, profit growth can suffer.

At issue now is what some investors see as a growing risk of a flattening yield curve under a more aggressive rate-hike path by the Fed.

Forwards pricing for two and 10-year Treasury yields suggests the spread between them would narrow to about 93 basis points by year-end from the current 122 points.

That is why Jeffrey Gundlach, chief executive officer at DoubleLine Capital and an early buyer of the Trump rally, said he has sold his financial stocks.

In the month after the November 8 US Presidential election the S&P 500 bank index rose 24 per cent. Since then the stocks have risen 5.7 per cent as many investors awaited concrete signs of regulatory and tax reform.

To be sure, the bank rally has been grounded on more than just rate hike expectations and yield curve forecasts.

Investor interest has also been stoked by assumptions about Trump’s agenda in Washington.

Investors have been betting that Trump’s promises of tax cuts would boost consumer spending and company profits, which would drive loan demand.

Meanwhile, his promise to slash regulations could also cut compliance costs and allow banks to expand their loan portfolios more rapidly.

That is among the reasons why David Lebovitz, global market strategist at J.P. Morgan Asset Management, still expects more gains for financial stocks.

Even if regulatory and tax reform looks like it would take a long time, investors would likely be patient as long as Trump’s administration provides more specifics on its plans including timetables, said Lebovitz.

But he cautioned that “disappointment on the policy front is the biggest risk” to stocks right now as investors have priced in policy changes already.