This Is Not a Good Sign for Bank Stocks

Slowing inflation could affect the Federal Reserve’s desire to continue raising interest rates.

John Maxfield
John Maxfield
Jun 15, 2017 at 2:44PM

There's a lot of noise right now when it comes to bank stocks. Between regulatory changes, a gradually improving economy, potential tax cuts, and of course, issues that are specific to individual institutions, it's hard to know what investors should keep their eyes on.

All of these issues are important, some more so than others. When it comes to the future direction of bank stocks in particular, investors should at the very least keep their eyes on unemployment and inflation. These make up the Federal Reserve's so-called dual mandate, which Congress laid out and obligates the central bank to strive to maintain maximum employment and stable consumer prices.

The Federal Reserve Building in Washington, D.C.

The Federal Reserve Building in Washington, D.C. Image source: Getty Images.

Things on the employment front look great. The unemployment rate in May came in at 4.3%. That's comfortably below the Fed's 5% target for the long-run normal rate of unemployment. It's also the lowest the rate has been in over a decade.

The situation on the inflation front isn't as optimistic. For the first three months of the year, consumer prices increased by more than 2% on a year-over-year basis. By April, however, they had dipped below that, coming in at 1.9%. And the latest reading shows a further decline, as consumer prices rose only 1.7% in May compared with the same month last year. Inflation is thus moving away from the Fed's 2% target, as opposed to toward it.

All of this matters for banks such as JPMorgan Chase (NYSE:JPM) and Bank of America (NYSE:BAC), because the Fed will be less likely to continue raising interest rates this year if inflation stalls or drops. Going into 2017, the Fed was expected to raise rates three times during the year, which would help bolster these bank's coffers, as higher rates translate into higher loan yields.

The Fed has already raised rates twice in 2017. The first time was in March, when it boosted the fed funds rate by 25 basis points, or 0.25 percentage points. It then did so again this week, raising rates another 25 basis points. All told, combined with a similar move at the end of last year, the central bank has now ratcheted the primary short-term interest rate benchmark in the United States up by 75 basis points in the past seven months.

US Target Federal Funds Rate Chart

US Target Federal Funds Rate data by YCharts.

Higher rates have come as a welcome relief to banks. JPMorgan Chase announced earlier this year that the rate increase in March, combined presumably with growth of its loan portfolio, would equate to $400 million more in net interest income in the second quarter relative to the first. And Bank of America will earn approximately $150 million more each quarter for every 25-basis-point increase in rates.

All of this goes a long way toward explaining why bank stocks have outperformed the broader market over the past 12 months. While the S&P 500 has gained 17%, Bank of America and JPMorgan Chase have seen their stock prices climb by 75% and 38%, respectively. But for this to carry on -- and both of these stocks have begun to trail the S&P 500 more recently -- interest rates and the economic environment need to continue improving.

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It's for this reason that investors in bank stocks would be smart to keep their eyes on unemployment and inflation. If the former starts to rise and the latter falls even further, the chances of another rate increase this year are slim to none.