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How Would a Rate Hike Impact the Banking Sector?

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Banks were anxious ahead of Fed meeting

The Federal Reserve met on September 16–17 to decide whether to raise policy rates. Bank stocks were volatile ahead of the meeting, as investors were anxious to know what course of action interest rates (TLT) would take following the meeting.

Banks constitute ~48% of the Select Sector SPDR ETF (XLF). During the trailing five-day period ended September 15, banking stocks within the Financial Select Sector SPDR ETF (XLF)  gained 1.03%. US Bancorp (USB), Citigroup (C), and Bank of New York Mellon (BK) led much of these gains and returned 2.23%, 1.87%, and 1.80, respectively, during this period.

Since the financial crisis of 2009, the Federal Reserve has kept its federal funds rate at near zero levels. However, prospects of improving economic fundamentals, as seen by unemployment data and inflation, have been preparing policymakers to raise these rates.

Although the Fed decided to keep rates steady at the meeting last week, it left a window open for future rate hikes. Let’s see how higher rates would impact banks.

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A rate hike and the impact on banks

Interest rates are the most important driver for a bank, as they determine the bank’s net interest margins. Banks are in the business of funding their long-term loans by short-term liabilities in the form of deposits. The spread between what they earn from these loans and what they pay out as interest on these deposits is called net interest income. As the yield curve steepens, these margins grow, thus improving profitability for banks.

So the timing of a rate hike isn’t as important to banks as the quantum and pace of subsequent hikes. If rates are hiked more than expectations, banks’ earnings grow and forecasts are raised, thereby leading to a rally in banking stocks. But if the Fed would have decided to raise interest rates now and put off further hikes, it would have shattered banking stocks.

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