U.S. markets closed

Interest Rate Cut Signals a Red Flag for US Bank Stocks

U.S. stocks have rebounded 5.1% from their 13.9% drop during the last week of February, bringing the market out of correction territory. This recent correction marks the fasted drop since the Great Recession and the fastest recovery in over a decade.

The market scare, driven by the novel coronavirus (Covid-19), prompted the U.S. Federal Reserve to cut interest rates by 50 basis points to a target range of 1% to 1.25%. This comes after the Fed cut rates by a total of 75 basis points in 2019.


Rate cuts are not be able to stop the virus or its effects on resulting supply and demand shortages. All they can do is make it slightly easier for companies to take out loans, so the main effect of this rate cut, especially in the short term, is to prop up investor sentiment and decrease panic-selling.

"The magnitude and persistence of the overall effect on the U.S. economy remain highly uncertain and the situation remains a fluid one," Fed Chairman Jerome Powell told reporters. "Against this background, the committee judged that the risks to the U.S. outlook have changed materially. In response, we have eased the stance of monetary policy to provide some more support to the economy."

The Federal Open Market Committee's decision was unanimous. In other words, it deemed a 50-point cut necessary in order to limit a short-term market correction. This begs the question, where will interest rates go if U.S. stocks see another coronavirus-related correction, or even a full-blown recession, in the future?

We'll pay you to borrow money

In 2014, the European Central Bank responded to the region's post-2008 debt crisis by cutting interest rates below zero. Within a couple of years, other countries followed suit, including Sweden, Denmark and Japan. Although the U.K. has not cut interest rates below zero, its rates have been close to the mark for years.

At a target base rate of 1% to 1.25%, the U.S. does not have much room left to cut interest rates before it reaches rates near zero. In previous recessions, the Fed has cut interest rates by at least 5% to stimulate the economy. However, if the U.S. markets were to enter a steep enough correction at current rates, it simply would not be possible to create the same levels of market stimulation without following in the eurozone's footsteps with negative interest rates.

Negative interest rates would mean that whenever you borrow money from a bank, the bank would pay you interest on that loan. Thus, after taking out a loan, it would make the most sense for a business to hold on to that debt for as long as possible instead of trying to pay it back quickly.

Low or negative interest rates are undeniably good measures to save an economy that is in deep distress. Nothing comes for free, though, and if rates really do go near or below zero, the profitability of the banking sector is likely to pay the price.

Can shareholders profit on extremely low interest rates?

The U.K.'s interest rates have been near zero since the Great Recession in 2008. Below is a chart of the stock prices of HSBC Holdings (NYSE:HSBC), Lloyds Banking Group (NYSE:LYG) and Royal Bank of Scotland (NYSE:RBS), the country's largest banks.

f5397c4aa371f2190514704c5e3282d4.png

The stock prices of Japan's largest banks, Mitsubishi UFJ Financial Group Inc. (TSE:8306) and Mizuho Financial Group Inc. (TSE:8411), also have continued to decline, while Japan Post Bank (TSE:7182) has also not done well since becoming publicly traded. Negative interest rates were implemented in 2016.

1cfd0cec87a7e2c2ee721c0bad621fa2.png

On the other hand, U.S. bank stocks have been more profitable investments in the wake of the 2008 collapse. JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC) and Wells Fargo's (NYSE:WFC) stocks are higher compared to 2009. Citigroup (NYSE:C) was excluded due to skewing the chart with its monumental collapse, but an investment in this bank from 2009 to 2019 would have returned more than 100%.

07de81ca1ddd343a33d96c82b28e84a7.png

Based off of historical examples from large-scale banks of major world economies, when interest rates are low or in the negatives, both banks and their shareholders are unlikely to see encouraging profits, especially compared to banks in countries with interest rates higher than 1%.

The economic conditions that necessitate the use of such low interest rates cannot be left out of the equation. If the Fed decreased interest rates to these levels in order to prop up a flagging economy, it seems likely that bank stocks would follow suit and give negative returns to investors, regardless of whether the cuts were made in a bear market or a bull market.

What about investment banking?

As interest rates in the U.S. have gone lower, the big banks have increasingly turned to investment banking as a source of growth. For example, both Citigroup and JPMorgan reported a 6% increase in investment banking in the fourth quarter of 2019, compared to mostly flat lending income as higher loan amounts were tempered by lower interest rates. JPMorgan posted an 86% increase in trading revenue compared to a 49% increase for Citigroup.

Base rates that are too low may prompt banks to get rid of interest paid on checking and savings accounts, or even increase the fees charged for these accounts. However, consumers not wanting to pay the fees could then choose to take their money out of big banks and move it to smaller, online-only banks, or even keep cash in a lockbox if that's the only way to preserve its value without investing in equity securities.

Compared to the other big U.S. banks, a larger percentage of JPMorgan's revenue (approximately 2.24%) comes from investment banking, which means that this only accounts for a small portion of its success relative to its peers. This source of revenue would have to show significant growth in order to reach the scale where it could make up for lower lending profits.

Investment banking and trading may also be particularly vulnerable to market downturns. While panic-selling may bring in some initial revenue from management fees, the eventual decline in the amount of money invested in stocks would take its toll.

Conclusion

While it is unlikely that debt-ridden companies will mimic the subprime mortgage crisis, U.S. banks could still see their profits and share prices decline if interest rates are continuously cut.

In general, the wisest investors, including Warren Buffett (Trades, Portfolio), recommend maintaining your investments during times of economic crisis as long as nothing has changed about their fundamentals. If a business is going to go on to increase its profits five or 10 years down the line, it makes no sense to sell its stock at panic prices. However, if the growth story has changed, it may be time to form a new investment thesis.

Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research and/or consult registered investment advisors before taking action in the stock market.

Read more here:



Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.