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Do Bank Stocks Go Up When Interest Rates Rise?

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Rising interest rates are generally considered to be a negative for the stock market as a whole. For starters, interest rates tend to rise only during inflationary periods. When inflation goes up, it means prices for everything from basic necessities to discretionary splurges are increasing, tightening the budgets of consumers. This not only hurts the profit margins of certain companies, it also raises concerns that the economy might tip over into a recession. 

This combination of factors often results in a market pullback. Bank stocks, however, have a different business model, and they can often benefit from a rise in interest rates.

Learn: 5 Things You Must Do When Your Savings Reach $50,000

Here’s a look at how bank stocks tend to perform during periods of rising rates, along with a quick look at how that compares to some other areas of the market. Bear in mind that past performance is not a guarantee of future performance, and that you should consult with your financial advisor before you make any moves in the stock market.

Benefits of Rising Rates for Bank Stocks

Are increased interest rates good for bank stocks? In general, bank stocks tend to benefit from a rise in interest rates — at least initially — due to the following factors.

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Increased Profit Margins

Unlike many other companies, bank stocks can often see increased profit margins during periods of rising interest rates. The reason for this is the way that banks are structured.

When you deposit money into your savings account, the bank doesn’t simply let it sit there while it pays you interest. Rather, it takes that money and loans it out to borrowers. The money a bank loans out will always be more expensive than the interest it pays on customer deposits, and that spread between the two is where banks earn a significant amount of their profits.

For example, a bank may pay out 2.00% APY on its savings account but loan money out at 6.00% APR. That 4.00% difference — less expenses and administration — is pure profit for a bank.

In a rising rate environment, a number of factors are happening that help banks earn money. For starters, loan rates always move up faster than the interest banks pay on deposits. Second, the amount that banks raise loan rates is usually much greater than the amount they raise their deposit rates.

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For example, if market rates jump by 0.75%, a bank may raise its loan rates from 6.00% to 6.75%, but it may only raise its savings rate from 2.00% to 2.25% or 2.50%. Not only are the banks earning more money on their loans in an absolute sense, the spread they’re earning between loan rates and savings rates also increases, further boosting profits.

When profits are rising, banks become more valuable, attracting more investors. But if you want to profit from bank stocks in a rising-rate environment, you’ll have to move early. The stock market is a forward-looking indicator, and it often moves as much as six months ahead of actual, tangible developments. As a result, bank stocks often go higher as soon as there’s a hint of inflation and rising interest rates in the economy, as investors want to buy the stocks before they actually report increased earnings.

Rising Dividends

One of the main attractions for bank stocks for many investors is their relatively high dividends. Banks in general are considered defensive, conservative companies, although there are some exceptions. 

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One of the defining characteristics of a defensive company is that it pays a fairly large and consistent dividend — and one that hopefully rises over time. When interest rates rise and banks start earning more money, they’re in a better position to pay a rising dividend.

This is another reason why investors like to accumulate bank stocks ahead of their actual reported earnings — they’ll often announce a dividend hike at the same time they are reporting increased earnings. The longer that banks can enjoy elevated spreads between loan rates and savings rates, the more profit they can make, and the more sustainable their dividends become.

Risks of Rising Rates for Bank Stocks

Although banks are generally better positioned to rise in value when interest rates increase, there’s not always a direct correlation. If investing were that easy, there would be a lot more millionaires in the world. In reality, the rise of bank stocks must still be evaluated on a case-by-case basis.

For example, if a bank is highly leveraged, it may actually suffer during periods of rising rates. If a bank has to refinance all of its outstanding loans at higher rates, this will actually eat into its profitability, which in turn will hurt its share price and potentially its dividend, as well.

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Another risk is that interest rates rise to the point that they become burdensome for borrowers. Home buyers couldn’t get enough of mortgages when they were below 3%, for example, but now that they have crested above 7%, demand has evaporated. Although a bank can still earn a good spread on the loans it does make, the number of those loans may shrink rapidly. The net of all this is that a bank’s earnings can fall, dropping its share price.

Macroeconomic risk is another consequence of interest rates that have risen too high. If rates are so high that they start slowing general economic activity, businesses may slow their borrowing and even start reducing their payrolls. This could lead to layoffs, which in turn typically slows consumer spending. If the overall economy falls into a recession due to high interest rates, banks are among the most negatively impacted.

Other Financial Stocks

Banks are not the only type of financial stocks that benefit during a rising-rate environment. Here are some additional types of financial stocks that typically generate more profits when interest rates rise. 

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Brokers

Brokerages benefit from rising interest rates in a number of ways. From an economic perspective, a rising-rate environment portends a growing economy in which consumers feel more confident. In this scenario, consumers are more likely to save, invest and trade, which increases transaction volume and therefore profits.

Rising rates also translate to higher margin rates, which generates additional interest income from customers.

Insurance Companies

Insurance companies are forced to hold tremendous sums of customer money in conservative investments like government bonds. When interest rates go higher, insurance companies earn more income on their investments. Insurance companies also benefit from a growing economy, as more prosperous customers buy more items that need to be insured, from cars and homes to boats. This increased activity generates additional profits.

What Stocks Rise When Interest Rates Rise?

At least at the outset, rising interest rates tend to indicate that the underlying economy is growing. This is generally beneficial for the stock market as a whole, but some sectors in particular tend to reap the biggest rewards.

Consumer Discretionary

Discretionary expenses are things that are not absolutely vital to life but that people enjoy indulging in when they have the money. Common examples include things like movies, travel, appliances and cars. While it’s true that many consumers buy these types of items at nearly any time, sales by and large increase during periods of economic prosperity.

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The simple reason for this is that when the economy is expanding, consumers generally tend to feel wealthier. If consumers are confident that they’ll keep their job — and perhaps even get a raise — they tend to spend more money on discretionary items. As rising interest rates often initially reflect an expanding economy, this is the time when consumer discretionary stocks also tend to outperform.

Industrials

Industrial companies also tend to shine when rates are rising and the economy is expanding. A growing economy has a ripple effect and tends to lift sales of everything from chemicals and truck parts to HVAC systems and construction equipment. These types of businesses thrive during economic expansion because more homes are being constructed and outfitted, more businesses are in need of raw materials and more transportation companies are carrying full loads of goods. 

The Bottom Line

Rising interest rates generally help banks because they can typically earn more money, as spreads between loans and deposit products rise. In fact, banks are at their most profitable in a rising-rate environment in which the economy is still growing strong.

But if rates rise out of the Cinderella zone, where everything is “just right,” a general economic slowdown can drag bank stocks back down. If rates tip the economy into a recession, banks generally lose all the benefits that higher rates provided them.

So, the short answer to the question “do bank stocks go up when interest rates rise?” is yes. However, the market is never as black-and-white as this type of blanket statement. Rising rates do indeed create a more favorable economic environment for banks, but individual companies may have their own issues with poor management, execution or capital structure that will hold them back. There may also come a time when rates rise too high, at which point economic activity contracts and banks start losing their profitability edge.

All of these possibilities should factor into your investment decision, so be sure to consult with an advisor before you start buying up any bank shares.