The Federal Reserve is now indicating that it is planning to start tapering its bond purchase program before the end of the year, and bank stocks may be benefit. Since July 2020, the Fed has been buying tens of billions in U.S. Treasury Bills and mortgage-backed securities each month in order to keep longer-term interest rates low. Bank stocks may benefit if the tapering does what it is supposed to do and boosts longer-term yields, which would be very positive for banks currently in this ultra-low-rate environment. Here's why.

How quantitative easing works

When an economy abruptly enters into a recession, the Federal Reserve will often lower its federal funds rate, the overnight bank borrowing rate and the central bank's benchmark short-term interest rate. All longer-term rates like those on U.S. Treasury securities are influenced by the feds funds rate. The Fed resorts to lower rates in a recession because it makes borrowing and lending easier.

But when the federal funds rate hits near zero like it did in March 2020, and the economy still needs help like it did in the unprecedented coronavirus pandemic, the Fed has to resort to other levers to aid the economy. One of those is quantitative easing, which is the purchase of U.S. Treasury bills and mortgage-backed securities, which increases the money supply in the economy and further keeps longer-term rates lower when the fed funds rate is already zero.

Federal Reserve building in Washington D.C.

Image source: Getty Images.

The actual prices for bonds like U.S. treasury bills and the yield attached to those bills move in opposite directions, so when bond prices are high bond yields are lower. When the Fed buys bonds, it lowers the supply of bonds, driving up the prices of the actual bonds, which then lowers the yields attached to them. Since July 2020, the Fed has been purchasing $80 billion of U.S. Treasury securities and $40 billion of agency mortgage-backed securities every single month. Look at the impact on longer-term treasury yields.

10 Year Treasury Rate Chart

10 Year Treasury Rate data by YCharts

As you can see, longer-term yields fell significantly during the worst of the pandemic in 2020, and then rose significantly to start the year. Longer-term yields are often a reflection of where short-term interest rates like the fed funds rate will go. With lofty projections for economic growth this year and then inflation, which typically leads to rate hikes, longer-term yields spiked early this year, but have since pulled back quite a bit.

Why rising long-term yields help banks

For most banks, their primary business is lending. Banks also buy securities such as Treasury bills to make yield on deposits not being used for loans and in order to preserve liquidity. Because banks typically borrow money on a short-term basis and make loans such as mortgages based on long-term rates like the 10-year treasury yield, higher longer-term rates typically improve their profit margins. This can be seen through the difference between the yield on the two-year treasury yield and the 10-year treasury yield, also known as the yield curve.

10 Year Treasury Rate Chart

10 Year Treasury Rate data by YCharts

As you can see, while rates were at all-time lows during some of the pandemic, the gap between the two-year rate and the 10-year rate widened, known as a steepening of the yield curve, which is very beneficial to banks. However, the steepening has subsided some as growth expectations have slowed in the near term and worries of coronavirus variants have come into play. When the Fed starts tapering its bond purchases, that should push up longer-term rates. It could also signal to the market that the Fed is following its time table to raise the federal funds rate by late 2022 or early 2023 because officials at the Fed have said previously they would like to end their bond buying program before raising rates.

This would also benefit most banks because it increases their yields on most loans, which will improve profit margins for those banks that can also effectively manage their deposit costs, which also go up with rates. Banks also expect to see some loan growth in the remaining months of 2021 and into 2022, which will give them the opportunity to originate loans at higher rates. They will also be able to reinvest securities at higher yields.

Not a guarantee

To be certain, the market may not react how it is supposed to. Despite the news that the Fed is planning to start tapering its bond purchases later this year, and rumors about it for the past few weeks, the yield on the 10-year U.S. Treasury has remained low. Furthermore, even when the Fed earlier this year indicated that it might raise the fed funds rate sooner than its initial timeline, long-term yields in recent months have remained low.

Why is this? Well, there are many reasons, but chief among them is the coronavirus. The delta variant has proven to be more challenging than many expected and could be an obstacle for higher long-term rates. Recently, data showed that U.S. retail sales declined 1.1% in July, compared to the 0.30% decline expected, largely because of fears related to the delta variant. If another surge of coronavirus cases slows growth and hurts the economic outlook for businesses and employment, the Fed may need to keep rates lower for longer to support the economy.

How to play it

If the Fed follows through with tapering this year, coronavirus variants do not impact the economy too much, and there is some modest loan growth, certain banks will benefit more than others because certain banks are much more sensitive to interest rates. One bank to benefit the most from higher long-term rates is Bank of America (BAC 1.70%). The bank disclosed in a recent regulatory filing that if long-term rates grow 1%, the bank would reap an additional $2.7 billion of net interest income over the next year. If the Fed increased its fed funds rate by 1%, Bank of America would see net interest income grow by a whopping $8 billion over the next year.

Wells Fargo (WFC -0.26%) is also very well positioned to benefit from higher rates, as are banks like JPMorgan Chase (JPM 1.44%) and Citizens Financial Group (CFG 1.22%). You can look in bank regulatory filings to see how sensitive individual banks are to interest rates, so do some research and invest wisely because I do think higher rates across the board are coming eventually.