Every indication seems to point toward a recovering economy, which is good news for shareholders of Bank of America (BAC -0.63%) and other banks who have been waiting for the Federal Reserve to raise the fed funds rate, the most important interest rate benchmark in the United States. The latest reading on the employment front offers yet more proof that the time might soon be right for the Fed to do so.
On Friday, the Labor Department released its employment data for the month of February. The economy added 235,000 jobs last month, which was down slightly from January, but was nevertheless a very good showing. The average over the past three months is only 209,000. And the monthly average over two years is 206,000. After accounting for the new jobs, the unemployment rate came out to 4.7% in February, remaining well below the central bank's 5% target.
Data source: Federal Reserve Bank of St. Louis, U.S. Labor Department. Chart by author.
From every indication we've gotten from the Fed, this strongly suggests that the central bank will indeed pull the trigger and raise rates at its meeting later this month.
Last week, Fed Chairwoman Janet Yellen said that "we currently judge that it will be appropriate to gradually increase the federal funds rate if the economic data continue to come in about as we expect." This was seconded by Fed Vice Chairman Stanley Fischer, who said that he "strongly supports" the opinion that rates should rise if economic data continues to be positive.
This is music to banks' ears. To understand why higher rates are so important, it's helpful to analogize a bank to a bookstore. Holding all else equal, if the prices of books go up, so too will a bookstore's revenue. Given that banks sell money, the price of which is denominated by interest rates, the same will be true for lenders when interest rates rise.
In Bank of America's case, it will already see a boost to its net interest income this year from the Fed's decision in December to increase the fed funds rate by 25 basis points, as well as by an earlier surge in long-term rates. These should add an extra $600 million to the bank's top line each quarter. Consequently, any added benefit from a future rate hike will be on top of this.
If the Fed raises rates, Bank of America will see its earnings rise. Image source: Getty Images.
To determine how much Bank of America will benefit from future rate hikes, one can find an interest rate sensitivity analysis in the North Carolina-based bank's annual regulatory filing for 2016, on page 84 of its 10-K. This shows that an increase of 100 basis points, or 1 percentage point, in short- and long-term rates should translate into $3.4 billion worth of additional net interest income a year. If you divide that by four, as the Fed seems poised to raise rates in increments of 25 basis points, you get $850 million in added annual net interest income, which equates to $212 million a quarter.
That's not a game-changing amount, as Bank of America earns around $4 billion a quarter, but it will add up quickly if the Fed raises rates an additional two times this year, as its current projections suggest. In fact, taken together with Bank of America's continuing efforts to trim expenses, it could mean that the $2.2 trillion bank might meet its top profitability goal on an annualized basis by the end of this year, which would mark yet another chapter in its post-financial-crisis recovery.
