Rising Interest Rates & Financial Stocks

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Rising interest rates have many implications for the economy and therefore the stock market. Many feel the Fed will begin increasing the Fed Funds Rate – the rate at which banks lend to each other, sometime this year. On a standalone basis, rising rates have the potential to be very beneficial for a handful of financial stocks.

For banking institutions in the business of taking deposits and extending credit to businesses and consumers, higher rates are expected to be a strong tailwind. Since these institutions borrow short term and lend long term, any steepening of the yield curve will increase their net interest margins or spreads, the difference between the rates they earn on loaned money and those paid on borrowed deposits. Some of the largest US banks estimate that higher net interest margins can generate billions of dollars of additional profit. These benefits, however, will not be immediate. Current loan portfolios likely contain a mix of fixed and floating rate notes where only the floating side will benefit from higher rates. As new loans are added to the mix at higher spreads, their benefits will accumulate over time and begin to materialize into the billions of expected profits.

Being some of the largest fixed income investors in existence, life insurance companies also stand to benefit from a higher net interest spread, similar to banks. Their spreads are the difference between the yield earned on their investment portfolios and the crediting rates paid on issued policies. As these institutions reinvest their coupon payments on their existing assets into higher yielding securities their investment income will grow. Further, many primarily purchase investment grade debt with the intention to hold them to maturity so the exposure to default and falling bond prices is relatively limited. While policyholders crediting rates are also likely to increase in order to stay competitive, they should not rise as fast and as much as the yield on their investment portfolios.

Derivative exchanges significantly benefit from market uncertainties, which result in elevated levels of price volatility in nearly every asset class, such as equities, bonds, interest rates and all kinds of commodities. Since there are a number of different views on the impact to the economy and the financial markets as a result of changes in interest rates, volatility will likely pick up over the next 12 months. As an example, many exchanges, such as CME Group*, saw record volumes for their products in the months leading up to the Fed’s recent end of their monthly bond buying program, which helps to keep a lid on interest rates.

On the other hand, a sudden and unexpected sharp rise in rates would be a detriment to these companies’ financial results, possibly with the exception of derivative exchanges as this would create a lot of volatility. However with the US economy continuing to add jobs at a steady pace and the potential for falling energy prices to keep a lid on inflation, along with slowing growth in many international markets, a sharp rise is unexpected.

In my opinion, 2015 is shaping up to be a very interesting year.

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