Rising short-term interest rates are expected to cause trouble for bank shares this week.

Investors view bank earnings as tied to changes in interest rates, so bank shares have moved in lockstep with the bond market since the end of the first quarter.

With the Federal Reserve poised to tighten credit and short-term interest rates rising, the market news is negative for banks.

By the Numbers

"You are going to see changes in investor sentiment based on interest rates, [President Clinton's] budget plan, and whether inflation numbers are high again," said Sam A. Marchese, investment manager for the SIFE Trust Fund, Walnut Creek, Calif.

The latest cause for investor alarm occurred last Thursday, when CNBC, a financial news network, quoted a senior Federal Reserve official as saying that 11 of 12 members of the policy-making Federal Open Market Committee now favor tighter credit conditions to curb inflation.

A Late-Week Selloff

A plummeting dollar has increased the likelihood of a tightening. One way to spur the dollar is to increase interest rates, which encourages investors to buy dollar-denominated securities.

Even without an official tightening, short-term rates are rising. For example, the bond-equivalent yield on one-year Treasury bills was 3.63% on Friday -- up about half a percentage point in the last month.

The specter of a tightening sparked another bank share selloff last Thursday and Friday.

Sellers believe that higher short-term rates would raise banks' cost of funds, thus eating into net interest margins and depressing second-quarter earnings.

In an illustration of just how closely bank shares' fortunes are tied to the outlook for interest rates, they rallied last Wednesday when Fed Chairman Alan Greenspan said he planned to hold the line on inflation.

Waiting for Indicators

The inflation fear is likely to remain until the producer price and consumer price indexes for May are announced -- on June 11 and June 15, respectively. Until then, money managers and analysts do not see the sector gaining much ground.

"Those are important days for the bank group," said Thomas Brown, an analyst with Donaldson, Lufkin & Jenrette Securities Corp.

Bank stocks stabilized last week. In the five trading days ending May 27, the American Banker bank stock index gained 0.81%, virtually in step with a 0.9% rise in the Dow Jones industrial average.

The worry about eroding net interest margins is misplaced, said money managers and analysts who remain bullish on the industry.

"I don't worry about margin compression," said Richard Pike, a portfolio manager at Chancellor Capital Management. "In talking with the banks, I find that not too many of them are worried about it."

Wide margins, said Mr. Pike, are not completely attributable to a steep yield curve that lets banks borrow at low rates and lend at high ones.

"If the fed funds rate went up 50 basis points, you wouldn't see a dramatic impact on any bank's earnings," he said.

With loan demand sluggish at many banks, there's no reason to raise deposit rates. Almost every bank relies on core deposits for funding, not wholesale funds.

Equity, which is at record levels, provides an interest-free source of funds. And nonperforming assets continue to fall, which should help buoy margins. Some banks had margins compressed in the first quarter, but still managed record earnings.

"I think the perception that margins will collapse if short-term rates rise is wrong," Mr. Brown said.

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