The Federal Reserve has a decision to make next week. It must decide whether now is a good time to increase interest rates, the Fed funds rate in particular, which could help to staunch recent bleeding in bank stocks.
The Fed funds rate is the interest rate at which banks lend excess reserves stored at the central bank to each other. A higher rate, means they make more money doing so. Even more importantly, because the Fed funds rate is the key short-term interest rate benchmark in the United States, all other rates are likely to respond in kind, pushing up loan yields and thereby filling banks' coffers with extra net interest income.
US Target Federal Funds Rate data by YCharts.
At Bank of America (BAC 1.34%), if the Fed funds rate increases by 100 basis points and long-term rates follow suit, the Charlotte, North Carolina-based bank expects to earn an additional $3.3 billion in net interest income over the following 12 months. The same figure for JPMorgan Chase (JPM 1.06%), the nation's biggest bank by assets, is $2.3 billion.
This obviously would make a big difference for banks, including Bank of America and JPMorgan Chase, which have struggled since the financial crisis to earn the types of returns investors expect from banks their size. Higher rates could fix this.
But this begs the question: Is the Fed actually likely to raise interest rates at its upcoming meeting next week? Investors seem to believe that it will, as you can see from the CME Group's FedWatch Tool, which gauges expectations around monetary policy. Currently, CME estimates a 96% probability that rates will rise by 25 basis points.
Image source: CME Group.
Those are pretty good odds. And if this happens, it will undoubtedly be welcome news for banks.
Yet, it's important to appreciate that interest rates don't exist in a vacuum. While higher rates would be good for Bank of America and JPMorgan Chase, there are additional factors that could offset any positive impact on their stock prices.
These include gridlock on Capitol Hill and a White House under investigation into links between the president's inner circle and Russian officials. As tax reform, healthcare reform, and infrastructure investments have all stalled in Congress, bank stocks have begun to give back some of their post-election gains.
The question investors need to consider now is whether or not higher rates, assuming they do in fact materialize next week, will more than offset these bearish influences. I'm skeptical that they will, and therefore think that prospective investors in bank stocks have more to gain than to lose by waiting on the sidelines before buying anything right now.
