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The US Federal Reserve’s decision to raise the Fed Funds rate by 0.25% came as no surprise to markets, and nor did their “pencilling” in of a further six rate rises in 2022 – one at each of the six remaining meetings. The infamous ‘dot plot’ showed that the Fed Governors expect the US Fed Funds rate to be about 1.9% by the end of 2022.
The action immediately led to speculation that Australian interest rates might rise faster, with the Australian Financial Review leading on Friday with the headline: ‘Fed rate rise pressures RBA’. Strong employment data, with the unemployment rate down to 4.0%, also added to the pressure.
Most economists still think that the RBA will be a “slow” follower, wanting to see wages growth before it really pulls the trigger with the first rate rise around June to August and a second by the end of the year. Possibly 0.75% by year’s end. But there are more hawkish assessments, with a couple of economists saying 1.25% to 1.5% by December.
Rate rises should be good for Australian banks, right? That’s the popular opinion, and one of the reasons that Australian bank shares have been well supported over the last few months.
Firstly, it is important to understand that this is the case in the US, so it is understandable why some less experienced commentators immediately make the assumption that if that is being said in the US about US banks, it automatically must follow with Australian banks. But the markets are different, the nature of banking is different and risk appetites are different.
In the US, the concept of “borrowing short to lend long” is well understood by bankers. So when interest rates go up, the yield curve usually steepens so that the interest spread (the difference between what banks pay for funds compared to the rate they earn on loans) increases. They become more profitable. They are also helped with the truckload of deposits they never pay interest on (usually cheque accounts and other business accounts), so when rates rise, they can lend these funds at a higher rate and don’t pay any more for the deposit.
The same is true in Australia, but our banks don’t take the same interest rate risk. Fixed rate loans are generally “swapped” back into 90 day bank bill exposure, so although a bank might be lending to a business or a home loan borrower for five years at a fixed rate, its actual interest rate exposure is being re-set every 90 days. Most of our home loan mortgages are priced at a variable rate which the bank can change at any time by giving 14 days’ notice, whereas, in the US, home loan mortgages are typically priced on a fixed basis relative to the US Government 30 year bond rate. Finally, our banks run concentrated books with mortgages and personal finance/small business loans, the big US banks have quite different loan portfolios.
That’s not to say that Australian banks won’t win when interest rates start to increase. But it won’t be by quite so much. To help the market understand this better, CBA provided the following information when announcing its half year result in February.
Looking ahead, CBA analysed the impact of higher cash rates on its book and profitability. It identified six drivers that would impact NIM (net interest margin) and classified 3 as ‘positive’, 2 as ‘neutral’ and 1 as ‘negative’.
It’s $170bn of ‘low rate deposits’ (these are deposits that are not sensitive to rising rates) would drive NIM accretion of 4bp over time. CBA’s current NIM is about 1.90%, so this would be akin to increasing it to 1.94%. On a loan book of about $1 trillion, this is $400 million to the bottom line – or $200 million in a half year.
CBA’s equity hedge would also drive profitability. It has about $50bn of capital that is hedged – and in time as swap rates go up, it will benefit. With higher rates, the recent flurry of borrowers fixing their home loan rate will shift back to a more normal pattern of largely variable rate loans. The margin the bank earns on a fixed rate loan is less than it earns on a variable rate loan. Offsetting these drivers are higher wholesale borrowing costs and the unwind of the term funding facility – a facility provided to the banks during Covid allowing them to borrow at very low rates from the Government and on-lend those funds to small businesses.
So, CBA and the other banks will benefit financially in the short to medium term from higher rates, but not by that much. And of course, if interest rates rise sharply and start to strangle the economy, businesses will go broke and consumers will get into financial stress. Bad debts will rise, and if it gets really bad, bank share prices will be trashed.
Good short to medium term – potentially a nightmare in the long term. And don’t think this can’t happen – just go back to the recession of the early ’90s (when Westpac almost went broke), or in more recent time, in March 2020 when the market expected (wrongly as it turned out) bad debts to soar due to Covid shutdowns.
CBA is best positioned of the major banks to win from higher interest rates because it has the highest proportion of ‘low rate’ deposits.
There is conjecture on this point with Credit Suisse saying CBA, ANZ and NAB are best positioned. Macquarie says the benefits in FY22 will be skewed to ANZ and NAB.
The major brokers continue to see the most value in ANZ and least value in CBA. In fact, all say that CBA is over-valued. While it is the best run bank, it is trading at too much of a premium relative to its peers. The table below shows broker consensus target prices and implied upside or downside to the target.
Interestingly, shareholder returns over the last 12 months are almost the exact opposite of the current broker ratings. CBA and NAB have outperformed ANZ and Westpac, as the table below shows.
Firstly, don’t get too carried away about “‘talk” that the banks are big winners from rising interest rates. They are winners, but the things they have most going for them at the moment are relatively stable earnings, viewed as ‘secure’ and ‘defensive’, nice dividend yields and bad debts that are very low by historical standards. In the medium-term, if the RBA goes too hard on rates, these factors could turn around but that’s low risk (at the moment).
Second, stay at least market weight on the sector.
Thirdly, in terms of “which bank(s)” my ‘one word’ assessment of the major banks is: CBA: “leader”; NAB: “‘up and comer”; ANZ: “asleep” and Westpac: “unclear”. Judging by the price action, I think the institutional investors, but not the analysts, agree.
While CBA is terribly expensive, I still think it is a combination of CBA and NAB. Thrill-seekers could add in Westpac. I Can’t see anything that suggests ANZ.
All prices and analysis at 21 March 2022. This information was produced by Switzer Financial Group Pty Ltd (ABN 24 112 294 649), which is an Australian Financial Services Licensee (Licence No. 286 531This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of WealthHub Securities Limited.