Here's What Bank Investors Need to Know About the Fed's Rate Hikes

When the Federal Reserve started the current rate-hike cycle, many experts thought it would translate into better profits for banks, which has historically been the case. However, the long-term interest rates from which banks make their money, such as mortgages and auto loans, haven't quite kept pace with the Fed's increases.

In this Industry Focus: Financials clip, host Jason Moser and Motley Fool contributor Matt Frankel, CFP discuss the rate-hike cycle and whether we can expect long-term interest rates to start climbing anytime soon.

A full transcript follows the video.

This video was recorded on Oct. 1, 2018.

Jason Moser: Let's kick off the discussion this week with interest rates. On Wednesday, perhaps to nobody's surprise, the Fed continued its measured approach in our recovering economy, raising interest rates just slightly. I wanted to get your quick take on things. What'd you think about the move?

Matt Frankel: Like you said, it was not a big surprise at all. In addition, nothing in the Fed's forecast was a big surprise at all. They're still planning to do one more rate hike this year and three more in 2019. For some context, this is the eighth time the Fed has hiked rates by a quarter point in the past three years since they started doing this rate height cycle. There's a little bit more to go. It looks like interest rates are going to go up by another 1%.

It's really important to note that not every interest rate is tied to the Federal Reserve. In other words, things like credit cards and home equity lines of credit, which have variable interest rates, are generally directly tied to the Fed's action. If the Fed raises rates, you can expect your credit card interest rates to go up by the same amount, for example. On the other hand, things like mortgages, auto loans, where the banks make the bulk of their money -- the majority of consumer debt is not directly tied to the Fed's action. For context, I mentioned that the Fed has hiked rates eight times, a total of 200 basis points. In that time, mortgage rates have gone up by about 80 basis points. These are not one-to-one. Longer-term interest rates have not quite caught up with the shorter-term ones.

From an investor's point of view, which is really what I wanted to get at, if you're a bank investor, you generally want higher interest rates, higher interest rates mean better spreads between what the bank has to pay customers for deposits and what they can charge for lending products. Generally, you want higher interest rates, but the interest rates that really matter to the bank's profitability -- mortgages, auto loans, etc. -- are not tied to the Fed's action and really haven't moved like many people would have expected them to.

At the beginning of this rate hike cycle, all you're reading, including from people like me, was, "Interest rates are going up, this should be good for the banks. It's a very positive catalyst." I think Bank of America actually put out something that says, for a 100-basis point shift in the yield curve, they would make another $3 billion in profit a year. But it really hasn't panned out. The reason is, when you look at long-term interest rates, particularly like the 10-year Treasury yield, they really haven't caught up with the Fed's rate hike moves. They've moved in the same direction, but not quite as much as people have thought.

Moser: Why do you feel like they haven't caught up, though? We're talking about that yield curve inverting. We hear on the news about the yield curve inverting, and oh, my God, the world's coming to an end. I mean, why haven't those long-term rates caught up with that short-term action yet, do you think?

Frankel: It's because, in my opinion, the market's not convinced that inflation is going to pick up and the Fed is going to have to raise much more than they think they will. The yield curve's getting very, very flat right now. It's between 2.5-3% across most maturities for a Treasury. It's gotten really flat because the market's not really sold that we're entering back into a normalized interest rate environment.

Moser: Inflation is that metric that has guided the Fed's actions, it seems like, a lot here, ever since the financial crisis took hold. And we haven't seen anything that has amounted to what I think a lot of people thought, maybe inflation was going to become somewhat rampant here. Is it something that we should expect? I mean, I don't know. I'm not an economist. I did some economics work in college, but this stuff all kind of kind of boils down to some speculation here, right, Matt? What can we expect on the inflation front, do you think?

Frankel: I personally think that in a couple of years, inflation is going to start to heat up a little more than the Fed wants it to. My personal opinion. Having said that, until the market's really sold on the fact that a stronger economy is going to lead to inflation... long-term interest rates haven't picked up that much. You saw it a bit today. When they announced the Canada trade partnership, you saw the 10-year yield jump today. The reason is because things like the trade deal make the market a little more optimistic that things will really get going, prices will start to rise. But, like I said, today's move is small potatoes. Until you see the 10-year really start to move, then you won't see mortgage rates, auto loans, things like that, get too overheated, and the banks won't get the big benefits of it, as I'll talk to a little bit more when we get to our One to Watch this week. A little preview.

Moser: If anything else, all of this tells us that the economy is on the mend. What we've wanted to see for some time is somewhat tighter monetary policy. Raise interest rates a little bit at a time, that is a sign, perhaps, that things are on the mend. We talked about last week, of course, FICO scores are at record highs, which means more people are capable of borrowing.

In the grand scheme of things, even with interest rates on the rise, they are still so low when you compare them to some of the historical norms. Going back to even my childhood, my mom and dad were getting mortgages on a house somewhere in the neighborhood of 14%. So, let's try to keep it all in context, right?

Frankel: Yeah, my parents bought the house I grew up in in 1982, and their first mortgage rate was 16.5%. It wasn't that they have bad credit or anything. That's just what the rates were at the time.

Moser: That was just normal.

Frankel: I think the Federal Funds rate actually peaked at about 21% at one point in the early 80s. I call a normal range for the Federal Funds rate around 4-5%. Right now we're at 2.25%. It's still very low from a historical standpoint.