The Federal Reserve's apparent shift away from an easy-money posture last week is likely to slow the year-long growth of banks' net interest margins.
However, economists do not expect a sharp increase in short-term interest rates that would drastically compress margins, the backbone of improved bank earnings this year.
"The banks will tend to do quite well over the balance of the year," said Jeff Thredgold, chief economist at KeyCorp, Albany, N.Y.
The Federal Open Market Committee met last week to set monetary policy for the next six weeks. Its deliberations are not publicized until later, but financial markets interpreted the Federal Reserve's failure to signal an easing last week as proof the central bank is content with present short-term rates.
In addition, a report in Thursday's Wall Street Journal said the policy committee had decided to change from nudging rates down to keeping them steady.
Turning Point for Rates?
This policy shift increases the chances that short-term rates, where banks typically fund their operations, will end their long fall and may even start creeping up later this year.
If such a rise occurs, it would squeeze banks' net interest margins.
Amid slack loan demand and a sluggish economy, interest margins have been a bright spot for banks. Margins were "the hero of first-quarter earnings," said Salomon Brothers analysts in a recent report.
The interest margin for a 50-bank group tracked by Salomon reached 4.02% in the first quarter, 14 basis points more than in the previous quarter and the highest level since 1986.
Buy Low, Sell High
Banks have taken advantage of a steep yield curve, the difference between short- and long-term rates, by using cheap short-term deposits to buy intermediate-term Treasury securities that pay higher rates.
The difference between three-month and five-year interest rates, a maturity favored by banks, is roughly 300 basis points.
While banks are unlikely to maintain these dazzling spreads, it is doubtful that short-term rates will rise sharply enough this year to take a big bite out of industry earnings, observers said.
Short-term rates are not likely to rise more than 12.5 to 25 basis points this year, according to Anthony Karydakis, economist at First National Bank of Chicago. The bank is a unit of First Chicago Corp.
The current recovery is moderate enough that inflation will not be a problem, said Mr. Karydakis, and the Fed will not need to raise short-term rates this year to slow economic growth - and inflation.
One More Easing Possible
A possibility remains that weakness in money-supply growth or other indicators could spur one last easing of short-term rates by the Fed, Mr. Karydakis said.
The moderate recovery and muted expectations of inflation will also bring down longer-term interest rates, predicted Charles Lieberman, director of financial markets research at Chemical Bank, a unit of Chemical Banking Corp. "The long-term rates will decline," he said, "but not a whole lot."
As a result, banks' returns on their investments in Treasuries will drop but not sharply enough to damage margins seriously. Lower long-term interest rates also may spur borrowing.
Long Rates Likely to Fall
Yields on the 30-year Treasury bond should drop about 25 to 30 basis points in the next three months, to 7.5%, with smaller declines at shorter maturities, said Mr. Lieberman.
Banks "will be able to continue to ride the yield curve," he predicted. "From a perspective of a bank, it's a good situation."