During the early days of the coronavirus pandemic, markets faced a lot of turbulence, with stocks and other assets selling off hard. To calm markets and ensure the smooth functioning of the financial system, the Federal Reserve cut interest rates to near-zero while the federal government spent trillions in fiscal stimulus.
As a result of those policies, along with semiconductor shortages, supply chain disruptions, and rebounding consumer spending, inflation has risen to rates not seen in decades. Last December, the consumer price index came in at 7%, the highest reading since 1982. One of the Fed's two mandates is price stability -- and rising inflation is tolerable as long as it hovers around the central bank's 2% target. However, we've seen inflationary readings above 2% for almost a full year now.
As a result, the Fed is expected to raise interest rates to tamp down inflationary pressures on the economy. One sector that is especially sensitive to rising interest rates is banking, and U.S. Bancorp (USB -1.49%) is a lender in prime position to take advantage of this environment.
Why interest rates will move higher
The Fed uses interest rates to stimulate the economy or cool it down, depending on the economic conditions. With inflation elevated, the Fed has indicated that it would raise rates for the first time since the pandemic began.
Interest rates affect all companies in one way or another, but some are more sensitive than others to changes in interest rates. The Fed is projecting three rate increases this year, and analysts at Bank of America expect as many as seven rate increases this year. With rate increases on investors' minds, it's good to understand how higher interest rates might affect the banking industry.
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How banks make money
One of the main ways banks make money is by charging customers higher interest rates on credit than they pay customers on their deposits. Some banks generate more money from fees, and some have highly profitable investment banking divisions, but for the most part, all banks generate earnings from interest rates.
Banks face more challenging times when interest rate spreads -- or the amount of interest charged minus the amount paid out -- narrows. Interest rate spreads often become compressed in low-interest rate environments. However, when interest rates rise, this spread tends to widen, and banks see their profitability improve.
Why U.S. Bancorp welcomes higher interest rates
One bank positioned well for rising interest rates rise is U.S. Bancorp. I like this bank in this environment because it generates more income from traditional banking activities than its peers do.
This didn't help the bank in 2021, when some of the nation's biggest banks benefited from an explosion in investment banking activities. According to S&P Global Market Intelligence, mergers and acquisitions (M&A) activity generated $3 trillion in deal value globally across over 35,000 deals. This benefited banks with investment banking businesses like JPMorgan Chase and Citigroup.
That bounty passed by U.S. Bancorp because it doesn't do investment banking. But this is precisely why I believe it will do well as we enter a rising interest rate environment.
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The bank has been preparing for rates to rise
In the fourth quarter, U.S. Bancorp saw deposits grow 4.3% to $450 billion, while loans grew 2% to $303 billion compared to the third quarter. Net interest margin (NIM) is a key metric banks use that shows how much the bank makes from loan interest minus how much it pays in interest on deposits. During the fourth quarter, U.S. Bancorp saw its NIM decrease to 2.40%.
While its NIM narrowed during the quarter, the reason for this shouldn't concern investors. During the quarter, the bank deployed excess cash to shorten the duration of its investments. This simply means that the bank didn't want to make investments that would lock in low interest rates over a long time period. While this type of investment hurt the NIM in the quarter, it was made to give the bank capital and flexibility to take advantage of rising rates in 2022 and 2023 to generate higher earnings in long run.
As economies continue to normalize this year and next, U.S. Bancorp is well positioned to succeed. Although it trades at a high valuation for a bank, with a price to tangible book value of 2.55, it trades there for a reason. The bank holds high-quality assets and has been a longtime holding of Warren Buffett. The bank has flexibility with its assets and investments to take advantage of higher rates, and its business should also improve as travel, airlines, and hospitality sectors bounce back.
