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Why Banks Are Anxious about the Fed Meeting

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Banks are anxious ahead of the Fed meeting

As December approaches, investors in financial markets (SPY) are getting anxious to know what the Fed will decide. The Federal Reserve is scheduled to meet on December 15-16 to decide whether to raise policy rates.

Bank stocks have been volatile ahead of the meeting, as investors are getting nervous about what the Fed will decide. In November, the Financial Select Sector SPFR ETF (XLF) has gained 2%. Fifth Third Bancorp (FITB), Regions Financial (RF), and Comerica (CMA) have led most of the gain, rallying 10.2%, 9.2%, and 7.4%, respectively, during the month. 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 are preparing policymakers to raise these rates. Now let’s look at how higher rates would impact banks.

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The Fed’s commentary on the future interest rate path will drive banking share prices

Interest rates are the most important driver for a bank, as they determine banks’ 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, and thus improve profitability for banks.

Thus, the timing of the rate hike is not as important to banks as the amount and the pace of subsequent hikes. If rate hikes exceed expectations, bank earnings will grow and forecasts will rise, thus leading to a rally in banking stocks. However, if the Fed raises interest rates now and puts off further hikes, it would shatter banking stocks. The Fed’s commentary on the future path of policy tightening will drive bank stocks.

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