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The Federal Reserve is widely expected to start reducing its massive portfolio of Treasuries and mortgage-backed securities after its two-day policy meeting ends on Sep 20. This will be for the first time ever that the central bank will unwind its crisis-era stimulus program. The bond selloff, in the meanwhile, is pushing the long-term Treasury yields higher. Such yields have also been climbing after U.S. consumer prices accelerated in August. This calls for investing in banks as such institutions will see increased profits with an uptick in Treasury yields.

Explaining the Fed’s Balance Sheet Cut

The Fed pulled the economy during the financial crisis by acquiring vast quantities of bonds and mortgage-backed securities. In this process, the Fed pumped in almost a whopping $4.5 trillion in government securities. This phenomenon is known as quantitative easing and was aimed at uplifting the economy by keeping long-term interest rates low. By holding down rates, the Fed made it easier for the U.S. government to finance budget deficits and for home buyers to apply for loans. It also reduced expenses for companies in China and other emerging economies that borrow in dollars.

The Fed, however, put an end to its buying spree in 2014 but refrained from pairing its swollen balance sheet until the economy showed signs of improvement. Now, most policy makers are expecting the unwinding process to begin later this year.

And why not? The U.S. GDP expanded 3% in the second quarter, the fastest in more than two years. An uptick in consumer outlays and business investment gave the economy a boost. Increased spending on goods and services pushed consumer expenditure up 3.3% in the said quarter. Additionally, the Empire State factory gauge hit 24.4 this month, while the new orders component of the report came in strong, as it reached its highest point since October 2009. The NFIB small business optimism index also remained healthy with a reading of 105.3.

The Fed, in the meanwhile, is expected to take baby steps in the unwinding process. As per the current plan, the Fed’s balance sheet is expected to initially shrink by only $10 billion a month. Later, the pace of the unwinding process will increase to a maximum of $50 billion a month. 

Treasury Yields Rise, Fed to Stay on Track for December Rate Hike

With the Fed expected to sell off bonds at a gradual pace, Treasury yields moved north. The benchmark 10-year Treasury yield was at 2.239% on Sep 19, compared with 2.230% the day before, while the 30-year bond yield edged higher to 2.810%, versus 2.804% on Sep 18. Banking behemoth Goldman Sachs (GS - Free Report) said that “we expect the announcement next week of Fed balance-sheet normalization, to begin in October, will lift 10-year Treasury yields.”

U.S. consumer prices, in the meantime, rose 0.4% in August, its biggest one-month gain since January. This has pushed the year-over-year increase to 1.9% from 1.7% in July. Inflationary pressure firmed in August and brought an end to five successive months of soft data. With inflation gradually climbing to the Fed’s target level, expectations of a further rate hike strengthened.

According to the CME Group, there is a 58.3% chance that the Fed will raise borrowing costs at its December meeting, up from 38% a week earlier. As per the CNBC Fed Survey, about 76% respondents believe the central bank will hike interest rates in December. Policy makers also see two to three rate hikes next year and forecast the end of the Fed’s rate-hike cycle in 2019.

Banks Ride the Wave of Steepening Yield Curve

Since banks lend over the long term and borrow for shorter periods, an increase in the long-term yield is beneficial for them. This boosts net interest margin, an important profitability metric for the banking sector. The spread between long-term and short-term rates also expands during interest rate hikes because long-term rates tend to rise faster than short-term rates.

Financial stocks in the S&P 500 cohort rose 0.8% on Sep 19, most in the index.  Shares of banking giants including Bank of America (BAC - Free Report) , Wells Fargo (WFC - Free Report) , Citigroup (C - Free Report) and JPMorgan Chase (JPM - Free Report) scaled 0.7%, 1.2%, 0.8% and 1.1%, respectively. In the last one-year period, all of these companies had registered double-digit growth.

Buy These 5 Bank Stocks Right Away

As higher yields bode well for lenders, investing in sound bank stocks will be judicious. Optimism surrounding President Trump’s plans to slash taxes and relax regulations has already provided an impetus to bank stocks. Moreover, banks have cleared the Fed’s stress test with flying colors this year. They have adequate capital cushion, which can be used for paying out dividends and repurchasing stocks.

We have, thus, selected five such stocks that flaunt a Zacks Rank #2 (Buy) and a VGM Score of B. Here V stands for Value, G for Growth and M for Momentum and the score is a weighted combination of these three metrics. Such a score allows you to eliminate the negative aspects of stocks and select winners.

Old Second Bancorp Inc. (OSBC - Free Report) operates as a bank holding company for Old Second National Bank that provides a range of banking services. The Zacks Consensus Estimate for its current-year earnings increased 2.9% over the last 60 days. The company’s expected growth rate for the current and next quarters are 58.3% and 11.8%, respectively. The company has outperformed the industry in the year-to-date period (+9.9% vs -4.7%)

Wintrust Financial Corp (WTFC - Free Report) conducts its businesses through three segments: community banking, specialty finance and wealth management. The Zacks Consensus Estimate for its current-year earnings increased 0.9% over the last 60 days. The company’s expected growth rate for the current and next quarters are 16.9% and 17%, respectively. The company has outperformed the industry in the year-to-date period (+0.2% vs -4.7%)

First Mid-Illinois Bancshares, Inc. (FMBH - Free Report) is engaged in the business of banking through its subsidiaries, First Mid-Illinois Bank & Trust, N.A. (First Mid Bank) and First Clover Leaf Bank, N.A. (First Clover Leaf Bank). The Zacks Consensus Estimate for its current-year earnings increased 4% over the last 60 days. The company’s expected growth rate for the next quarter is 12.7%. The company has outperformed the industry in the year-to-date period (+2.8% vs -4.7%). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Park Sterling Corp (PSTB - Free Report) is a holding company for Park Sterling Bank (the Bank). The company provides banking services to small and medium-sized businesses. The Zacks Consensus Estimate for its current-year earnings rose 1.7% over the last 60 days. The company’s expected growth rate for the current and next quarters are 9.5% and 14.3%, respectively. The company has outperformed the industry in the year-to-date period (+7.3% vs -4.7%).

TriCo Bancshares (TCBK - Free Report) is a bank holding company. The company's principal subsidiary is Tri Counties Bank, a California-chartered commercial bank (the Bank). The Zacks Consensus Estimate for its current-year earnings increased 5.2% over the last 60 days. The company’s expected growth rate for the current and next quarters are 3.2% and 3.7%, respectively. The company has outperformed the industry in the year-to-date period (+2.9% vs -4.7%).

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