wait a moment

Stocks rise, rates decline as Yellen stays the course

A trader watches the markets at the NYSE. (File Photo).

Stocks rallied and Treasury yields declined as Janet Yellen maintained a dovish outlook in her press conference, emphasizing that even if the Fed raises rates it will be “gradual.”

The Fed statement was almost a carbon copy of the April 29 statement. The only change came in the first paragraph on the economic outlook.

The Fed has:

1) modestly upgraded the economic outlook: “has been been expanding moderately after having changed little during the first quarter.”

2) modestly upgraded the assessment of the labor market: “The pace of job gains picked up while the unemployment rate remained steady.”

3) upgraded its view on housing: “Growth in household spending has been moderate and the housing sector has shown some improvement”

4) left in the key inflation line: “The Committee continues to monitor inflation developments closely.”

5) left in the key statement on fed funds rate: “economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”

6) downgraded their 2015 GDP forecast to 1.8-2 percent from 2.3-2.7 percent in March.

Bank stocks: How much more room to run?

The Fed has influenced one important part of the stock market: bank stocks have been going strong recently. The theory is, buy banks when rates go up because higher rates are good for banks.

That idea has worked….since the last Fed meeting with a press conference on March 18, the SPDR Bank ETF, a basket of bank stocks, has risen nine percent to a seven-year high, as interest rates have inched up.

Many regional banks in particular, such as Suntrust , have hit new highs in the last few days, though not today.

The problem is, a small rise in interest rates does not necessarily translate into more revenues for banks.

First, banks get revenues form a mix of fees and interest income.

For interest income, what’s good for banks is a steepening yield curve. That increases revenues because it enables them to “borrow short, and lend long.”

But rising rates doesn’t always mean the yield curve steepens. They could raise rates and the yield curve could flatten…that is, short term rates could rise significantly and longer term rates rise less so.

A second problem is what the loans are pegged to. For many banks, rates are tied to LIBOR–the London Interbank Offering Rate, which is determined by banks in London based on what the average leading bank would be charged if borrowing from other banks.

What this means is that LIBOR is not directly tied to Treasuries or the Fed Fund rate. Just because Fed raises rates it doesn’t mean LIBOR rates go up.

Most adjustable-rate and subprime mortgage loans, for example, are tied to LIBOR.

My point: there is a natural knee-jerk reaction to buy bank stocks in a rising interest rate environment. But the connection between rates and higher revenues is not iron-clad.