All eyes are on the Federal Reserve this week as its monetary-policy committee meets to decide whether to unleash another round of quantitative easing in an effort to further depress long-term interest rates. Widespread anticipation that it will err on the side of taking action has caused the markets to skyrocket in recent days despite an onslaught of bad news from Europe, China, and the United States. In what has historically been the worst month of the year for stocks, the Dow Jones Industrial Average is already up by 2.3% in September.
While bank stocks have joined the rally, a further easing isn't categorically good for their bottom line. The purpose of traditional monetary policy is to drive down short-term interest rates, which, in turn, drives down a bank's borrowing costs. This is good. On the other hand, the purpose of quantitative easing is to drive down long-term interest rates, which, in turn, drives down a bank's yield on earning assets. This is bad.
Take a look at the following chart. As the spread between two- and 10-year Treasury bonds narrows, which happens when short-term interest rates are near zero and long-term rates decrease, the average net interest margin of banks follows suit. Because this margin dictates net interest income -- the most important profitability metric for a traditional bank -- it stands to reason that a lower margin is necessarily bad for banks.
Source: FDIC; the Federal Reserve Bank of St. Louis.
The impact this is having on lenders is immediately apparent. Of the four money center banks, only Wells Fargo (NYSE: WFC ) hasn't seen its net interest income decline over the five periods inclusive of Q2 2011 to Q2 2012, and that was due to offsetting growth in its loan book. The rest experienced declines regardless of underwriting trends. Bank of America (NYSE: BAC ) led the way down with a 15% decline, compounded by a contraction in loans. JPMorgan (NYSE: JPM ) was next despite healthy asset-expansion, and Citigroup (NYSE: C ) experienced the least bad decline.
Change in Net Interest Income (Q2 2011 to Q2 2012)
Change in Loans (Q2 2011 to Q2 2012)
|Bank of America||(15.1%)||(4.8%)|
The moral of the story
What this means for investors is that the rally among bank stocks in anticipation of more quantitative easing may not be sustainable. At least with respect to Bank of America, the real impetus for an increase in share price is much more nuanced and multifaceted. To discover the levers underlying B of A's success, check out our in-depth report on the bank, which covers both the opportunities and pitfalls associated with owning stock in the nation's second-largest lender, as well as reasons to buy or sell. The report also comes with a year of updates. To get your investing edge, click here.