The Federal Reserve raised interest rates at its latest meeting, but there's more important information you need to know. In this episode of Industry Focus: Financials, host Michael Douglass and Motley Fool banking specialist Matt Frankel break down the key takeaways and how they could affect your investments.
A full transcript follows the video.
This video was recorded on March 26, 2018.
Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, March 26th, and we're talking about the latest Fed meeting. I'm your host, Michael Douglass, and I'm joined by Matt Frankel. Matt, as you noted in an article, and we're using that as part of our discussion today, the fact that the Fed raised rates this latest meeting wasn't actually the biggest piece of news out of the meeting.
Matt Frankel: No, it actually wasn't too surprising at all. The market was already pricing in about a 95% chance that this rate hike would happen. We have a recent tailwind with this tax reform, and other positive economic news has made it almost a certainty. So, this may as well have actually happened before it happened. The good news, rather, was the Fed's forecast. The Fed is getting a little more confident about the economy, I guess we'd say. We'll get into the actual numbers in a little bit. But, the Fed is getting a little more confident about the economy and seeing rates in the future going a little higher than they had predicted last time. So, this is the big story.
Douglass: Let's break that down piece by piece. The Fed releases a document that is known as the dot plot four times each year. That basically contains members' projections of where rates are headed over the next few years, basically so that things get priced in. The fact that the market had priced that 95% chance of a Fed rate increase was in large part because of a past dot plot. But let's talk about this one, because things changed.
Frankel: Dot plot is generally a projection of the next three years of interest rates and what the Fed sees happening over the long run. Contrary to popular belief, the Fed does not like to surprise the market. The Fed wants the market to know where it's going and where it sees things going. This one, the numbers went up a little bit from last time. The previous Dot Plot, just to give you some of the numbers, called for rates going to 2.1% this year, which is about where it's going. That hasn't changed much. 2019's target has gone up considerably from 2.7% to 2.9%. In interest rate terms, that's a big shift. 2020 has risen from 3.1% to 3.4%. This means that investors should expect rates to go a little higher than they were previously expecting over the next few years.
Douglass: And I think the big thing for folks thinking about just this year, is, in between 3-4%. That definitely implies a Fed that's getting progressively more hawkish.
Frankel: Yeah. And it's also worth mentioning that the members of the Fed tend to gravitate toward the same rate. There's a lot of agreement on these dot plots. Most are within 50 basis points of each other. There's a few outliers. That's actually one this time that thinks rates going to get to about 5% by 2020, which I actually found one of the more interesting points of the dot plot. But, generally speaking, all the dots are clustered around a consensus interest rate, which is why the market prices in moves like the one we just had so much.
Douglass: Right. And that, in a lot of ways, is a very good thing. The problem with the dot plot is that it's a projection, it's a prediction, and there are weaknesses there. We'll get to that more in a minute. But, it's a really good thing that the market, to some extent, has some expectations about things, because frankly, the market really, really hates uncertainty and even if the certainty is bad, sometimes I think the market prefers that to an uncertain, possibly good outcome. So, in this case, it's a really good way for basically the Fed to not cause a massive reaction every time it moves things, but instead to smooth out that volatility.
Frankel: Yeah, definitely, the whole point of the Fed is to create stable financial markets. That's kind of the whole point of the Dot Plot, they don't want to surprise everybody.
Douglass: Right. So, let's talk a little bit about GDP and unemployment, because the Fed basically broadly sees things getting better in both areas. And of course, this makes sense when you think about it from a rising interest rates environment. The Fed is going to raise interest rates if it believes that the economy is going to continue expanding, and therefore to basically control inflation they're going to keep raising those interest rates to ensure that the economy doesn't expand at this unsustainable rate.
Frankel: Yeah. The Fed's purpose is to try to find a nice equilibrium in the market. There was a point in the early 1980s, for example, where interest rates were 14-15%. And the Fed's goal is to avoid situations like that from happening. When you see the economy growing faster than what they call their target, they'll try to slow down the rate at which they're increasing interest rates or even reduce interest rates. But, now the Fed is expecting GDP and employment, which are two of their biggest indicators, to be even better than expected in the coming years. For example, next year, the Fed was originally projecting 2.1% GDP growth. Now, that's up to 2.4%. Unemployment, they were previously projecting 3.9% next year, now it's down to 3.6%. I might be wrong about this, but I can't remember it getting to that level in my lifetime.
Douglass: [laughs] It's certainly very good news for the economy, that the Fed feels that way. But, we're long-term investors, so let's also consider the fact that the Fed doesn't necessarily see this as a long-term rate of expansion. The Fed's dot plot certainly implies that they see some economic cooling off, let's say, post-2020.
Frankel: Right. First of all, the Fed doesn't really see inflation getting out of control, as you might expect from GDP and employment numbers like that. That's better than what's known as full employment. The Fed is expecting inflation to hover around its 2% target, which is why it's feeling so comfortable with the projected rate increases over time, and also why after 2020, the Fed is expecting the economy to cool off a little bit.
One key thing to note from the dot plot, they're expecting about 3.4% to be their target interest rate in 2020. And over the longer term, meaning beyond that, they're expecting about 2.8% to be the target. So, they're expecting interest rates to be reduced a little bit after 2020. Now, nobody knows when exactly the economy is going to cool off. There are a thousand different variables that could cause GDP growth to slow down or unemployment to pop up. No one knows when it's going to happen. But the Fed, given the information they have now, sees the economy heating up until about 2020 and then cooling off a little bit afterwards.
Douglass: Right. And again, lowering that interest rate implies a desire to make lending money a little bit easier, aka to stabilize, let's say, an economy that has cooled off a little bit. But, let's also talk about this from another perspective. When the Fed makes a prediction, people listen. Understandably so. It's the Fed. This is what they're saying they plan to expect out of the economy, and a lot of market expectations are built into those predictions.
But, I also feel the need to point out, The New York Times published this lovely article in December of 2017, which I'm going to jokingly say was ambiguously titled, "When the Forecasters Get It Wrong: Always." Just to quote the article briefly here, "The consensus of leading economists has consistently missed big turns. They have not predicted a single United States recession since the Federal Reserve began keeping such records a half-century ago." So, when you think about that, people are human, people cannot predict the future. And frankly, it can be very difficult long-term to see where things are going. If you look at the history of the federal funds rate, which is the benchmark rate that the Fed sets, it peaked in late 2007, right before the massive financial recession that we have only somewhat recently gotten out of. It's worth pointing out here that predictions of the future are notoriously, well, inaccurate.
Frankel: Yeah, even in that situation, in 2007, the Fed wasn't projecting a recession right around the corner.
Douglass: Right. Had it been, it would have done some things.
Frankel: Right. But, the Fed's goal is to have enough room to lower interest rates when it needs to and raise interest rates when it needs to, which is a big priority and why they want to get to that 3% range over the long run. This way, when a recession hits, they'll have some ammunition to lower the interest rate gradually and not immediately go to zero like we saw last time. The Fed likes to do things on a gradual basis. And as rates normalize -- right now they're still on the much lower end historically -- they'll have a little more ammunition to keep a stable economy, which is the ultimate goal of this.
Douglass: Absolutely. Alright, Matt, we've given the general gist of things and the lay of the land from the Fed's perspective. Let's talk a little bit about the key takeaways for investors. Now that we've given all of this information, let's try and distill it down. Of course, the first thing that bears mentioning is, an expanding economy is generally good for just about everybody stocks-wise. But there are still going to be disproportionate winners, and also some potential losers. Let's talk a little bit about disproportionate winners first.
Frankel: The biggest disproportionate winner is banks that make their money off of interest rates, that's the whole reason they're there. Generally speaking -- we did a three-part series on banks earlier in the year, and it's a little more complicated than this, but the general idea is, banks take in deposits at low interest rates and loan out money at higher interest rates. The difference between them is known as the net interest margin. This is the profit margin in the banking world.
As interest rates rise, the rates that banks pay out rise as well, generally, and the rates that they charge consumers for loans tend to rise, as well. But, the rates that they're charging on loans tend to rise a little bit faster than the rates that they're paying out on deposits. If you have a savings account, you'll notice that your interest rate probably has not gone up by 150 basis points in the current rate hike cycle. This results in what's called margin expansion, where banks' profit margins get a little bigger as interest rates get higher, which we've already started to see over the past few years in a lot of the major banks.
Douglass: And, in fact, Bank of America CFO noted on their most recent quarterly call that, "With respect to asset sensitivity as of 12-31, an instantaneous 100 basis point parallel increase in rates in estimated to increase net interest income," or NII, as he called it, "by $3.3 billion over the subsequent 12 months." That's a big difference. And it's worth noting that, especially now that we're still near the bottom of the interest rate cycle, there's a lot of margin expansion potentially open to banks.
Frankel: There's definitely some margin expansion that happens when interest rates are at the lower end of the spectrum. You'll see this taper off if interest rates start to get a little on the high end, like 5% at the federal funds rate like Michael just mentioned. But, for the time being, we're still close to what you would call a normal level of interest rates. So, over the next few years, you should see margins expand significantly at most U.S. banks.
Douglass: Right. Interestingly, just this morning, when we were talking through and prepping for the show, I pulled net interest margin from S&P Market Intelligence for Bank of America, Citigroup, Wells Fargo, JPMorgan. These are the big four banks. And I looked at what net interest margin looks like in 2017 and what it looked like in 2006, before the financial crisis.
What's interesting is, in 2006, Bank of America and Wells Fargo had bigger net interest margins than they do today. That's not terribly surprising, that's kind of how that's supposed to work. But Citigroup and JPMorgan had smaller net interest margins than they do today. And given that, again, there was a significantly higher federal funds rate, and we think a significantly higher federal funds rate will lead to net interest margin expansion, well, that doesn't really totally make sense. Now, of course, there are a few countervailing issues here, Matt, as you pointed out when we chatted about this.
Frankel: Yeah. Well, first of all, pretty much any comparison between a bank now and the same bank before the financial crisis happened is not a complete apples to apples comparison. There are a lot of assets that were on bank balance sheets, especially institutions like Citigroup back then, that are no longer the case. So, you really can't judge that too much. I'd say, if you want to see the effects of margin expansion, look at banks that are more like a traditional savings and loan that did well during the financial crisis, Wells Fargo being one of them. You mentioned that Wells Fargo had a significantly higher net interest margin in '06 than they do today. This is a case where you can really see the effects over time. Just keep in mind when you're looking at pretty much any bank that had a tough time during the financial crisis that you're not looking at the same bank 10 years ago.
Douglass: Right. And this is actually one of the interesting problems when thinking about interest rate cycles -- they tend to run fairly long, and this one has run very long by historical standards. What that means is, getting an apples to apples comparison between any two time periods can be somewhat difficult, because this isn't the sort of thing where there's a massive change in interest rates in a year or two, usually. So, it's really very difficult to see from a historical perspective how these things work, because so much has changed. Think about how much the world has changed since 2006, even leaving aside the financial crisis. The first iPhone happened in 2007. So many things have changed and shifted that it's really difficult to get a good historical perspective there.
That said, Matt and I have talked, and we're going to dig into this a little bit more, and we're going to plan to have a deep dive episode on this at some point in the next couple of months, once we've really cut through all the different components of this. And we think that's pretty exciting.
Thinking, then, about folks who might benefit less or even lose a little bit in a higher interest rate environment, there are a number of sectors and areas we can talk about here.
Frankel: Yeah. Real estate is definitely a big one. I'll call myself one of the losers here, because I own a lot of real estate investment trusts. Generally anything that is an income-based investment -- think high-dividend stocks like REITs, think bonds -- tend to do poorly when interest rates rise. The yields go up, which is why the prices go down, as interest rates rise. If you're buying bonds now or in the future, you can expect a higher yield on them. If you're holding bonds that you already bought in the past, the value of those bonds will go down in order to make the yields rise. The same holds true for dividend-focused stocks like REITs like I mentioned. I can personally tell you that as rates have started to rise over the past couple of years that the REITs in my portfolio have been the worst performers. So, I wouldn't expect anything different over the next few years, although I still love them as long-term investments. They're not going anywhere.
Douglass: Right. The REIT part of my portfolio has not been the worst-performing part of my portfolio, but that's because I've bought some real duds over the years [laughs] that have not been REITs, but have been other companies that have really struggled. Every investor has their stories of stocks that have, let's just say not gone quite as they predicted, and I certainly have my fair share of them.
But, this is an important point for us to note and to really consider, which is that as bond yields go up, we can probably expect some income investors, perhaps some of our listeners, even, to think about, "I could be in this dividend aristocrat, this very comparatively safe dividend stock, which is paying a 2-3% yield. Or, I can be in this bond that's paying 4-6%, depending on how things go with interest rates." And that could really make for this interesting trade off, where you might really rather get the income. One of the reasons so many retirees and income-focused investors have been in dividend stocks have been because bond yields have been so low for so long. As that shifts, it really could have some big implications for, broadly speaking, the dividend sector.
Frankel: Definitely. I'll be honest, if I saw a pretty safe bond that was yielding 6-7%, I'd have to think twice about taking risks on a certain stock I was looking at. So, you could definitely see this put pressure on income investments, stocks and bonds, over the next few years.
Douglass: Right. Of course, that assumes that the Fed continues raising rates, and that bond yields continue to improve, etc. As I mentioned earlier, predicting the future is not something people are really terribly good at. We're not planning to predict the future here, but this is certainly a possible outcome. And there's a lot to think about. But broadly speaking, if you have some banks on your watch list, now is a pretty good time to take a closer look at them. Frankly, this sector looks poised to have a really good few years, assuming the Fed's predictions and planned actions continue to hold.
Frankel: Definitely. And don't forget about the potential banking reforms we talked about last week.
Douglass: Right, yeah, another potentially big benefit, particularly to some of your mid-size banks. Alright, folks, that's it for this week's Financials show. Questions, comments, you can always reach us at firstname.lastname@example.org. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!