What happened
Shares of Citigroup (C +2.23%), as well as other megabanks including Bank of America (BAC +1.28%) and JP Morgan Chase (JPM 0.37%), traded down about 5% each on Wednesday, trailing the S&P 500 on what has been a miserable day for stocks. Investors are fleeing the market because a key recession indicator was triggered, and that particular indicator could mean significant pain for the financial sector.
So what
The big banks traded down after the 10-year Treasury yield fell below the two-year Treasury yield. In normal times, investors require a bigger payday to accept a longer maturity length. When short-term rates are higher than longer-term rates, a so-called inverted yield curve occurs and it's usually a sign of economic uncertainty and a sign that recession is imminent.
Image source: Getty Images.
It's worth noting that an inverted yield curve is far from a perfect predictor of recessions and in fact has occurred a few times in the last year before the market then rebounded. But a flattening or inverted yield curve does tend to be bad news for banks, whether or not a downturn follows.
Banks make their money by borrowing at short-term rates and lending based on long-term rates, which is why deposits pay less than the cost of loans. As the normal market distorts and yields come together, the spread a bank can make between borrowing and lending rates decreases, making it harder for financial institutions to generate huge profits.
Considering just six months ago, investors were anticipating that the Federal Reserve would raise rates multiple times this year and therefore boost bank profitability in the second half of 2019, this latest inversion is particularly demoralizing to investor expectations.
Now what
Citi, Bank of America, and JP Morgan are all moving in tandem on the day, and all figure to be impacted by the current rate environment. But for investors considering bargain hunting, there are differences between the institutions that would likely make them appeal to different types of buyers.
Citi is the least expensive of the three, trading at just 8.5 times earnings compared to 9.4 times for Bank of America and 10.7 times for JP Morgan, in part because of Citi's outsized international exposure that makes it more vulnerable to potential trade wars between the U.S. and China. Citi figures to either underperform or outperform its peers based on how the international economy is performing relative to the U.S.
Bank of America, meanwhile, has spent most of the last decade in the shadow of JP Morgan but has, in recent quarters, made steady progress improving results and closing the gap.
There's a lot of uncertainty in the market and growing pressure on the U.S. consumer, but with unemployment remaining low and credit quality, as measured by financial institution charge-offs, still manageable, I'm skeptical that the inverted yield curve is really sending a signal about what the future holds. It's also worth noting that all three of these banks have the wherewithal to survive an eventual recession once it inevitably comes and should be able to maintain dividend yields, which are all now north of 2%, through a moderate downturn.
It could be a turbulent few quarters for these bank stocks given the current interest-rate environment. But for investors who have a long-term horizon, panic selling like what's happening on Wednesday marks an attractive opportunity to buy in.
