Increasingly, economists see reason for bank stock investors to hope that interest rates are about to reverse course, ending a six-month erosion of their stock's value - and possibly leading to a rally in the second half of the year.
They point to a recent run-up in yields on Treasury securities, saying bonds typically react this way in anticipation of Federal Reserve rate increases - the next Fed meeting is Feb. 2 - then level off and eventually begin to subside after the central bank swings into action. Besides that, rates often rise in the first quarter of the year, for both technical and fundamental reasons, and then gradually slip lower.
Recently the yield on the benchmark 30-year Treasury bonds has advanced at a gallop - to 6.72% on Friday from 6.16% on Dec. 10. But that was exceeded last week by the yield on 10-year Treasuries, at 6.78%. Some bond traders said this inversion at the long end of the Treasury yield curve suggested that a peak in rates may be near.
If the dramatic six-week rise in bond yields is indeed setting the stage for a substantial reversal in the trend later on, that could spark a rally in bank stocks - which customarily track bond market trends because of their perceived interest sensitivity.
"Treasury yields and 30-year fixed mortgage rates will soon reach the upper ends of their respective 6.25% to 6.75% and 7.75% to 8.25% ranges, before declining toward the lower ends of those ranges later this year," said Stuart G. Hoffman, chief economist at PNC Bank Corp. in Pittsburgh.
Others think the bond yield peak could be higher.
Edward Yardeni, chief economist at Deutsche Bank Securities in New York, thinks it will be near 7%, while Ian Shepherdson of High Frequency Economics in Valhalla, N.Y., forecasts 7.25%. Both see prospects for an improved environment in the second half, though Mr. Shepherdson cautioned that "it will get worse before it gets better."
Rates have risen recently not so much because of inflation, which remains quiet, but because of the stiff investment competition that bonds are encountering from stocks - other than banks stocks - at a time when credit demand remains brisk because of a strong domestic economy and reviving economies overseas.
"Rates do tend to rise in the first part of the year during most years, although not usually after a year when they have already moved up from 5% to 6.5%," said Frank W. Anderson, an independent banking industry analyst based in Dallas. "Yields have had to go up to entice investors into bonds at all versus the big returns that could be gotten in the stock market."
And yields could continue moving upward until that dynamic changes, he said. "Unfortunately, higher rates are going to have more impact on some industries than others, and that means banks and financial services."
As Mr. Yardeni put it, "that great sucking sound last year was money pouring out of bonds and into stocks instead." Like the comedian Rodney Dangerfield, he said, bond investors "have been getting no respect by clipping their coupons with a 6.5% annual return while the stock crowd is getting 20% or more."
Mr. Yardeni anticipates a strong economy this year, following the dissipation of year-2000 fears he once felt might cause a recession. Together, consumer spending and high-tech capital spending could easily push the inflation-adjusted annual growth of the economy above 4%, he now believes.
Meanwhile, "competition from stocks might continue to push the bond yield toward 7% during the first half of the year," he said. "This would make already undervalued bonds even cheaper. By the end of the year they should be back to 6%." In 2001 he thinks the yield could move back toward 5%.
These scenarios suggest the stage is set for a second-half rally in bank stocks. Economist Joseph Carson of Warburg Dillon Read in New York thinks the Federal Reserve's current 5.5% short-term rate target can still be considered expansionary. He believes the Fed needs to raise the federal funds rate another half percentage point just to put it in the neutral zone when the strong momentum of the economy is considered.
Considering current and prospective trends for nominal economic growth as well as the flow of liquidity, "the historic evidence is unambiguous over where the federal funds rate is headed," Mr. Carson said in a yearend assessment. "Both measures point to an increase in the rate of 100 to 150 basis points over the next year or so."
In other words, a 7% federal funds rate. That would be higher even than the 6% rate of early 1995, after the Fed had raised rates for a year on concerns of reviving inflation. It implies double-digit levels for both prime bank lending rates and mortgage rates, both unseen in years.
That is beyond Mr. Carson's own current forecast. Right now he expects a 6.5% funds rate by the end of the year and yields on the 30-year bond climbing above 7%.
Also anticipating significantly higher rates is Kenneth T. Mayland, chief economist at KeyCorp in Cleveland, who thinks another 125 basis points could ultimately be added to the funds rate as the money supply undergoes a cyclical contraction to avoid inflation. Money supply growth has slowed sharply over the past year, but not to previous cycle lows.
The notion that the Fed might avoid increasing interest rates in a presidential election year should also be dispatched, said Warburg's economists. The central bank raised rates sharply in 1980 under the leadership of chairman Paul A. Volcker, with the funds rate rising above 17% to combat inflation. More recently, under Alan Greenspan, the Fed raised rates seven times between March and October 1988. That pushed the funds rate to 8.25%, its most recent high, from 6.5%.
Of course, as all the economists point out, a sharp price correction in the stock market before rates ever reached such levels could alter the climate quickly.
Such a development would surely induce the Fed to shift gears quickly, making bank stocks appear a bargain as well as a safe haven.
