If you own shares of Bank of America (BAC 1.70%) and have followed the bank's story over the past few months, then you may have been surprised to see that its shares didn't rally on Wednesday, despite the Federal Reserve's decision to raise interest rates.
This should have been good news for Bank of America, given that the Charlotte, North Carolina-based bank will earn more money as interest rates go up. In its latest quarterly financial filing, Bank of America disclosed that a 100-basis-point increase in short- and long-term rates should translate into an additional $3.3 billion in added quarterly net interest income.
Bank of America Chairman and CEO, Brian Moynihan. Image source: Bank of America.
The problem, though, was that both short- and long-term rates didn't go up today. Short-term rates did, thanks to the Fed's decision to increase the Fed funds rate by 25 basis points, or 0.25 percentage points. But long-term rates fell, as the yield on the 10-year Treasury bonds declined from 2.21% at open down to 2.14% at market close.
The net result was that, at least insofar as interest rates are concerned, today was a mixed bag for Bank of America. There was good news, but it was accompanied by bad news.
US Target Federal Funds Rate data by YCharts.
It's hard to say exactly why long-term interest rates dropped, but there are two likely culprits. The first is that the latest inflation data, released Wednesday morning, shows that the rise in consumer prices is decelerating.
Through the first three months of the year, core inflation (all consumer goods, less food and energy) came in at 2% or higher. This began to decelerate in April, when the figure fell to 1.9%. And it dropped further in May, down to 1.7%.
This isn't a promising trend. It suggests that the economy isn't as robust as many had assumed, which could eventually weigh on the demand for loans, the principal product sold by banks. In addition, the rate of inflation is one of two primary variables the Fed weighs when making monetary policy decisions, the other being unemployment. As inflation drops, so too does the Fed's incentive to continue raising interest rates.
Data source: U.S. Department of Labor. Chart by author.
The second culprit was a report from the Commerce Department on U.S. retail sales, a critical component of gross domestic product. Retail sales fell 0.3% in May compared to the prior month. This is bad in and of itself, but exacerbating the impact on the markets was the fact that analysts had expected the measure to increase 0.1% last month.
Lower retail sales affect Bank of America in two ways. First, it means that consumers bought less, and thus likely used their debit and credit cards less. This reduces the interchange income Bank of America earns every time a person pays for something with a card issued by the bank.
More important than this is what the decline in consumer purchasing activity may say about the direction of the economy. If the trend continues, the country could very well see itself enter a recession. That's still a long way out, but retail sales are a leading indicator of economic activity. And if a recession were to materialize, not only would Bank of America see loan demand wane, it would also experience an uptick in loan defaults, which would impair its bottom line.
Thus, while it's certainly a positive thing that the Fed increased short-term rates for the second time this year, that wasn't enough to offset the otherwise negative impact on the market from lower-than-expected inflation and retail sales in May.
