By Owen Davis -
For the nation’s largest banks, it’s a $10 billion question: Will the U.S. Federal Reserve bump up interest rates in its upcoming meeting, or keep them scraping zero? If the Fed’s decision-makers opt to raise rates in the near term, it will be lucrative for banks’ central business of taking deposits and making loans.
It might be the luckiest industry. Amid the clamor and din surrounding the Fed's meetings Wednesday and Thursday, analysts and economists are puzzling out who wins and who loses if the Fed raises rates in September. After a near-decade of unprecedentedly low interest rates, the Fed has to balance a desire to return to ordinary rates with a dual mandate to bolster employment and contain inflation.
According to analysts, banks could do quite well. A rate increase would have a more mixed impact on non-bank financial institutions and corporations, whose fortunes are intertwined in the complex interplay of debt markets and currencies. Ordinary wage-earners, meanwhile, might lose out on the labor market improvements that rock-bottom interest rates encourage.
Breathing Room For Banks
In the near term, major banks would see higher profits if the Federal Open Markets Committee -- a meeting of Federal Reserve Bank branch presidents and governors -- decides the time is now to raise rates.
That’s due to so-called net interest margins, the difference between what banks pay to borrow in the short term and the interest they charge on long-term loans. Part of that equation is determined by the federal funds rate up for discussion at the Fed this week, which determines how much big banks pay for government credit.
As that rate has hovered around zero for the past seven years, banks have seen the rates they can charge borrowers steadily decline, leaving their net interest margins at three-decade lows.
“The banks have been suffering under low interest rates for a long time,” says Chris Mutascio, a bank analyst at Stifel, Nicolaus & Co. “Their net interest margins have been squeezed because you can’t lower your deposit cost anymore than they are.”
According to quarterly filings, which require banks to estimate earnings in different interest-rate environments, the five largest lenders in the U.S. would see a combined $10 billion in new profits from their lending operations. JPMorgan Chase & Co (NYSE:JPM). estimates it would pull in $2.7 billion if interest rates increased by 1 percent over the course of the coming year. The Fed is expected to be considering a modest 0.25 percent hike in the near term and a slow rise after.
What’s more, the profits require basically no new costs. “You can almost just sit on your hands -- when interest rates go up, you make more money,” Mutascio says.
A little breathing room on interest rates wouldn’t be the only potential boon for the banking sector. An interest rate hike is expected to stir up the stock market. Volatility is often profitable for banks’ trading arms, even if they can no longer freely speculate.
There’s no guarantee, however, that banks will be able to make the most of turbulence in equities. The same goes for the bond market, which will inevitably be roiled by rising interest rates. Bond funds are bracing for a potential hike.
Despite these uncertainties, Mutascio says, the financial sector is eager for the Fed to act. “These banks are clamoring. They would like some relief.”
Debt And The Dollar
For other industries, a rate hike would be a mixed bag. Private equity firms and hedge funds rely heavily on borrowed cash, meaning higher interest rates would increase the cost of doing business. But these sectors are more concerned with the pace of the Fed’s potential rate increase than precisely when it starts, says private equity analyst Jeremy Swan of the advisory firm CohnReznick.
“It’s not going to be anything that will really change the tide,” Swan says of a rate rise.
In the broader business world, a rate hike’s impacts depends largely on corporations’ international exposure and the amount of floating-rate debt they hold.
Higher interest rates would strengthen the dollar, as international capital eager for safe yields flowed into the greenback. But a stronger dollar means a tougher export environment. Companies like Apple (NASDAQ:AAPL) that derive a significant portion of their earnings from overseas sales would feel the pain.
Companies that carry a heavy load of free-floating debt, meanwhile, would also be sensitive to even a small rate increase. Goldman Sachs’ Chief Equity Strategist David Kostin recently indicated that companies including General Electric (NYSE:GE), Wells Fargo (NYSE:WFC) and Progressive all fall into this camp.
The low interest rates of the past several years have stoked a massive build-up in corporate debt. In the next five years, according to the Financial Times, some $4 trillion of that debt comes due. Though investors don't expect bold moves from the Fed, rising rates could spell trouble for deeply indebted companies.
As far as earnings expectations go, however, few investors may end up with a surprise. The Fed has telegraphed its intentions to raise rates slowly and in tune with stable market conditions with uncommon opennness. “Everybody and their mother has higher interest rates on their earnings statements for 2015-2016,” says Mutascio.
The Rest Of Us
For ordinary Americans juggling mortgages, car loans and careers, a rate hike has few obvious benefits -- aside from potentially staving off wealth-destroying inflation. The possible drawbacks, however, loom large.
Prominent progressive economists, including Nobel prizewinners Joseph Stiglitz and Paul Krugman, have taken to the editorial pages to agitate against a September rate increase. With key inflation measures still lagging behind target rates, they say, the Fed should hold back on nudging up rates.
“The direct effect on most middle-class borrowers won’t be that strong,” says Michael Madowitz of the liberal-leaning Center for American Progress. “It’s really the indirect effects that we worry about -- this is basically a policy that’s going to slow the economy down.”
The immediate pain of rising interest rates fanning out across mortgages, auto loans and personal borrowing would likely be muted, economists say. But a rate rise would communicate the Fed’s faith that the economic recovery of the past seven years is complete.
Madowitz says it's too early to make that call.“You’re either reacting to conditions or you’re not. We’re not seeing conditions where you want to see rates going up.”
With nearly six million workers hired in the past two and a half years, the jobs market has inarguably improved. But as Stiglitz points out, what some call the true unemployment rate, which includes counts reluctant part-timers, is 10.3 percent, well above the headline 5.1 percent rate. And wage growth has hovered around 2 percent, far shy of the 3.5 percent the Fed considers healthy.
Madowitz explains that the stimulative effects of low interest rates largely benefit ordinary workers. A premature rate rise could cut the recovery short, he says.
Others feel the labor market has improved sufficiently. Rick Reider, chief fixed-income investment officer at BlackRock, has recently argued that “the Fed’s dual mandate” -- stabilizing prices and boosting employment -- “has been achieved beyond a reasonable doubt.”
Regardless of the FOMC's final decision this week, that debate is likely to carry on for the foreseeable future.