The Federal Reserve and America’s big banks have a close relationship. Maybe too close.
This relationship formed more than a century ago. And there’s a not-so-far-fetched conspiracy theory that it formed specifically to serve big banks. (If you really want to take a trip down the rabbit hole, read this.)
Today’s chart shows that this connection is alive and well.
Above, we have plotted the S&P U.S. Bank Index and the federal funds upper target rate. As you can see, bank stocks have moved higher as rates have increased.
Over the last 12 months, U.S. banks have outperformed the S&P by 154.29%.
This is largely because of two rate hikes in December of both 2015 and 2016. These were the first hikes the Fed had made since 2006, before the financial crisis forced Fed policy to go “zero bound.”
And after the FOMC meeting this coming Wednesday, big bank stocks should run even higher.
Below, I’ll show you how you can profit from this rising trend. But first, let’s examine why rates should move higher this week.
Another Federal Reserve Bump?
The Fed is holding its infamous Federal Open Market Committee monthly meeting on Wednesday. Fed Chair Janet Yellen and her cronies will decide whether they will jack up rates or leave them be.
Will they push the interest rate lever up a notch?
Strong economic data and Trump’s recent speech have pushed the needle toward a rate hike.
Today, the probability of a March hike is close to 100%. Two weeks ago, it was in the 30% range. So the likelihood of a 25 basis points bump - from an upper target rate of 0.75% to 1% - is high. Very high.
Many believe a March hike is a done deal. A probability close to 100% helps confirm that. Especially after last Friday when Yellen stated, “In short, we currently judge that it will be appropriate to gradually increase the federal funds rate.”
Strong language from a person known for vagueness.
Even if a hike somehow doesn’t come this month, future hikes could spark more rallies in bank stocks. And investors are pricing in possible deregulation in the industry as well. This could save big banks millions in compliance costs. It’s yet another reason bank stocks have been surging higher.
Why Big Banks Love Rate Hikes
The relationship between the federal funds rate and banks’ profit margins is a correlation every investor must know about.
The profitability of banks increases every time there is a rate hike. It all has to do with cash.
Banks hold vast amounts of cash. Think of all the cash you have stashed at your local bank... hopefully. Customer checking and savings accounts and business deposits make up these big pools of cash.
Big banks like JPMorgan Chase (NYSE: NYSE:JPM), Wells Fargo (NYSE: NYSE:WFC) and Citigroup (NYSE: NYSE:C) are currently sitting on $23.8 billion, $20.7 billion and $23.0 billion in cash, respectively.
And when rates move up, the yields banks earn on their cash goes up. This directly boosts their bottom lines.
It’s all thanks to the “spread” - the difference between the rate banks pay depositors and the rate at which they invest in short-term notes. When rates rise, the spread increases in the short term. And this extra cash goes straight to the bank’s earnings.
That’s the reason why bank stocks have been on a tear over the last year... and the reason why bank stocks rally whenever there’s a hint of rate hikes to come.
Come Wednesday, a rate hike and a big bump in bank stocks is expected.
An easy way to play this trend is with the iShares US Regional Banks (NYSE:IAT). Its top holdings include US Bancorp (NYSE:USB), PNC Financial (NYSE:PNC) and BB&T (NYSE:BBT).
And if you want a more aggressive play, consider the Direxion Daily Regional Banks Bull 3X Shares (NYSE:DPST). This leveraged ETF hands you three times the performance of U.S. bank stocks.
If banks jump 3% on Wednesday, the ETF would increase 9%. This play comes with more risk, since it also drops three times when bank shares pull back. If you have a weak stomach, stick to the traditional ETF.