Canada's central bank just announced a surprising one percentage point increase in interest rates. It is clear that the country is worried about fast-rising inflation, but the cure could push Canada into a recession.
The same basic story holds true for the United States. And yet there's both good and bad news here for banks like Bank of Montreal (BMO 2.35%), Toronto-Dominion Bank (TD -0.47%), and Royal Bank of Canada (RY 0.76%).
The bad news
The clear concern today is that inflation is running too hot. That eats away at the buying power of money and makes people feel increasingly unhappy as their cash buys less and less over time. The solution is to get inflation under control, which generally means central banks increase interest rates. The U.S. central bank is doing just that, as is Canada's central bank. Recently both have been erring on the side of larger rate hikes, with Canada's 1% increase a move that suggests its central bank is very concerned that prices are getting out of hand.
Some inflation is a good thing, but too much can lead to material economic problems. The thing is, rising interest rates can result in an economic contraction if central banks aren't careful. Recessions, when they come, are not good for banks. The decreased economic activity leads to lower demand for the products and services banks offer. And economic downturns usually lead to an increase in the amount of bad debt that banks have to deal with.
Canadian banks are well positioned on both fronts. First, the Canadian banking sector is highly regulated so that a few large players have entrenched positions. So, even if there's a downturn, it is unlikely that Canadian bank giants Bank of Montreal, Toronto-Dominion, and Royal Bank of Canada will see their industry positions materially weakened.
Moreover, Canadian regulators tend to push a conservative approach, leading to these banks having very robust Tier 1 capital ratios. This ratio is a measure of how well a bank can handle adversity, with higher numbers better than lower ones. Bank of Montreal's Tier 1 ratio was a huge 16% at the end of the fiscal second quarter, TD Bank came in at 14.7%, and Royal Bank of Canada's number was 13.2%. By comparison, Citigroup's Tier 1 ratio at the most recent quarter-end was 11.9%.
Based on this important industry metric, it looks like these Canadian banks are extremely well positioned to weather a downturn -- just like they did during the Great Recession when each held its dividend level even as U.S. counterparts were cutting their payments.
The good news
Central banks increasing interest rates, however, isn't all bad news for banks. Essentially, banks can only charge just so much for the loans they make, and the rates are indirectly dictated by central bank rates. Over the recent past, rates have been historically low, so banks have not been able to charge much for their lending services. That means lower earnings.
With rates on the rise, however, banks are able to increase the amount they charge for loans. And if they increase the amount they pay on things like bank accounts at a slower clip, they can quickly expand the amount of money they make. In other words, rising rates should lead to improved longer-term earnings prospects for the banks. There may be some short-term pain to deal with if there's a recession, but for financially conservative banks, like Bank of Montreal, Toronto-Dominion, and Royal Bank of Canada, that should be relatively easily dealt with.
But investors tend to think about the next quarter, not the next decade. So bank stocks have sold off, pushing dividend yields higher. If you can think long-term, this is an opportunity. Bank of Montreal's yield is 4.7%, Toronto-Dominion's is 4.5%, and Royal Bank of Canada's is nearly 4.4%. You'll have to pay foreign taxes on those dividends (which can be clawed back come April 15), and exchange rates will change the quarterly total U.S. investors actually receive. However, if you are looking for reliable dividends in the financial sector during a tumultuous time, this trio could be just what you want.
Hold your nose
A recession will happen eventually, even if central banks' rate hikes don't lead to one right away. So there will be a bad period for banks to live through at some point, likely sooner rather than later. And that will be a problem for Bank of Montreal, Toronto-Dominion, and Royal Bank of Canada to deal with. However, history suggests that they will take the hit in stride, a fact supported by their currently strong Tier 1 capital ratios. The risk/reward balance here seems tilted in favor of reward today.