Bank Stocks and Higher Interest Rates: A Recovery Rally Needed to Prove Economic Stability

DataTrek Research suggests that bank stocks are in need of a "recovery rally" to demonstrate that higher interest rates won't inevitably lead to a recession in 2024. Nicholas Colas, co-founder of DataTrek, highlights that U.S. bank stocks are currently the market's weak spot and their performance could be indicative of the overall health of the economy.

This year, the SPDR S&P Regional Banking ETF (KRE) has seen a significant decline of about 31%, while the SPDR S&P Bank ETF (KBE) has tumbled approximately 21%, according to FactSet data. In comparison, both funds have dropped around 3% this month alone, surpassing the S&P 500's decline of approximately 1% during the same period.

Colas acknowledges that U.S. bank stocks have not reached new 52-week lows despite the spike in interest rates. However, there is cause for concern as their recent momentum is heading in the wrong direction. Sentiment towards this group is notably negative, with dividend yields on most S&P 500 bank stocks pointing to potential declines in earnings power over the next year.

The Federal Reserve's ongoing efforts to combat inflation through rapid rate hikes have placed stress on regional banks. Earlier this year, Silicon Valley Bank unexpectedly failed, leading the Fed to implement an emergency lending program for banks to ensure their ability to meet depositor needs.

The recent surge in bond yields, as investors adjust to the expectation of prolonged high rates, has reignited concerns surrounding banks. Colas warns that if higher yields devalue a bank's bond portfolio, they may need to secure additional capital or sell at distressed prices. Additionally, if higher yields result in a recession, loan losses are likely to increase.

It remains crucial for bank stocks to demonstrate their resilience and rebound with a strong recovery rally. This will alleviate concerns about the impact of higher interest rates and instill confidence in the strength of the overall economy.

The yield on the 10-year Treasury note (BX:TMUBMUSD10Y) has experienced a significant surge in 2023. Currently trading at approximately 4.71% in the early afternoon on Thursday, it recently reached its highest level since August 2007 based on 3 p.m. Eastern Time levels, according to Dow Jones Market Data.

Despite facing losses, both the SPDR S&P Regional Banking ETF and SPDR S&P Bank ETF saw modest gains on Thursday afternoon, as shown by FactSet data.

Beaten down U.S. bank stocks are catching the attention of bullish investors.

"If you are very bullish here, this is the group for you," states Colas. However, DataTrek takes a more cautious stance on banks at the moment.

When the dividend yield of an individual stock triples that of the S&P 500 (currently at 1.6%), it typically suggests that a dividend cut is looming and the earnings power is significantly lower than anticipated by management and their board, explains Colas.

DataTrek indicates that the market believes, "rightly or wrongly," that 11 out of the 17 banks in the S&P 500 index may need to drastically reduce their dividends within the next six to 12 months. Colas recommends waiting until Fed rate cuts are imminent and dividend cuts have begun.

Meanwhile, the U.S. stock market experienced a decline on Thursday afternoon, as investors processed data showing a slight increase in initial jobless claims within a still strong labor market. The Dow Jones Industrial Average (DJIA) was down 0.4%, while the S&P 500 (SPX) and the Nasdaq Composite (COMP) fell by 0.5% and 0.6% respectively.

Despite losses incurred in September and August due to concerns about higher rates, the S&P 500 has recorded a year-to-date gain of approximately 10%.