Strong inflation numbers published by the Bureau of Labor Statistics on Friday morning gave banks a big boost.
At 2 p.m., shares of the SPDR S&P Regional Banking Exchange-Traded Fund (KRE, Financial) were up 0.40%, while shares of the Financial Select Sector SPDR Fund (XLF, Financial) gained 0.36%.
Rising inflation is usually followed by higher long-term interest rates, helping to widen the spread of the yield curve, the difference between short-term and long-term interest rates.
A wider spread, in turn, boosts bank profitability. Banks borrow funds on the short end of the curve from depositors and lend them on the long end of the curve by extending loans to businesses or buying long-term government securities.
According to the Federal Reserve Bank of Saint Louis, the interest rate spread increased from nearly 0.60% back in July 2019 to around 1.70% in April.
Meanwhile, banks have benefited from a strong housing sector, which has helped demand for mortgages stay high during the Covid-19 pandemic.
Still, investors should temper their enthusiasm for banking stocks, as they have already had a big run-up, discounting the widening of the interest rate spread.
Meanwhile, the mortgage market is beginning to show weakening signs rather than strengthening as the U.S. economy recovers from the pandemic. Mortgage applications dropped 5.1% in the week ended April 2, the fifth consecutive decline, as higher mortgage rates caught up with homebuyers. Applications to purchase a home dropped 4.6%, and home refinancing declined 5.3%.
Then there is the state of debt markets, which are pricing in a lift-off in short-term interest rates by around year-end 2022, and three cumulative rate increases by 2023, according to a Deutsche Bank (XTER:DBK, Financial) research note posted last month.
Rising short-term interest rates aren't good news for banks. They narrow the spread, the source of profitability from bank core operations.
The bottom line is inflation can turn from a tailwind to a headwind if it forces the Federal Reserve to raise short-term interest rates sooner rather than later.
Disclosure: No positions.
Read more here:
- Inflation Is Back on Wall Street's Radar
- The Fed Reassures Markets About Easy Monetary Policy as Jobless Claims Rise
- How Aflac Has Become a Winner in Japan and on Wall Street
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