The Federal Reserve indicated that the central bank is likely to begin withdrawing some of its stimulatory monetary policies before the end of 2021. Although interest rate hikes are likely off in the distance, the economy has reached a point where it no longer needs as much monetary policy support. This pivot in monetary policy by the Federal Reserve sets the stage for the initial reduction in asset purchases and downstream interest rate hikes. As this pivot unfolds, risk appetite towards equities hangs in the balance. The speed at which rate increases hit the markets will be in part contingent upon inflation, employment, and of course, the pandemic backdrop. Inevitably, rates will rise and likely have a negative impact on equities.
A string of robust Consumer Price Index (CPI) readings spooked the markets as a harbinger for the inevitable rise in interest rates. Although rising rates may introduce some systemic risk, the financial cohort is poised to go higher. Moreover, the confluence of rising rates, post-pandemic economic rebound, financially strong balance sheets, a robust housing market, and the easy passage of annual stress tests will be tailwinds for the big banks.
2021 Financial Stress Tests Easily Pass
The recent stress tests were easily passed and indicated that the biggest U.S. banks could easily withstand a severe recession. In addition, all 23 institutions in the 2021 exam remained "well above" minimum required capital levels during a hypothetical economic downturn.
The central bank said that the scenario included a "severe global recession" that hits commercial real estate and corporate debt holders and peaks at 10.8% unemployment and a 55% drop in the stock market. While the industry would post $474 billion in losses, the Fed said that loss-cushioning capital would still be more than double the minimum required levels.
Pandemic-related restrictions hindered the banks' ability to return capital to shareholders via dividends and buybacks. Those restrictions will now be removed based on the recent stress test results. So now, the banking industry can hike buybacks and dividends by billions of dollars starting in July 2021. Nearly all banks have since increased their payouts to shareholders.
The prospect of rising interest rates coupled with fantastic earnings has propelled bank stocks to all-high highs. Citigroup (C), JPMorgan (JPM), Bank of America (BAC), and Goldman Sachs (GS) have appreciated to all-time highs this year. Rising interest rates in combination with the highly disruptive COVID-19 backdrop abating have served as the foundation for this move higher. The big banks responded and evolved in the face of COVID-19 to the real possibility of widespread loan defaults, liquidity issues, ballooning credit card debt, and stressed mortgages. To exacerbate these COVID-19 impacts, interest rates, Federal Reserve actions, yield curve inversion, and liquidity heavily weighed on the sector.
Nevertheless, the big banks have demonstrated their ability to evolve in the face of COVID-19 and present compelling value. Now with the prospect of rising rates, this may serve as a long-term tailwind for banks to appreciate higher. This is especially true now that the banks have retreated from their highs.
COVID-19 and 2008 Financial Crisis
The big banks are far stronger and more prepared than they were during the 2008 Financial Crisis. Lessons learned from the Financial Crisis yielded rigorous annual stress tests that forced banks to maintain a slew of fiscal discipline measures. With the Federal Reserve working in hand with the banks, a financial bridge to those businesses and consumers negatively impacted by COVID-19 as a stop-gap measure has been afforded as this pandemic moves to the rearview and economic activity rebounds, the banks' present value even after these all-time highs. Add in the prospect of higher rates, and the banks are set up for long-term appreciation. Their strong cash positions and healthy balance sheets allow dividends to continue, and share buybacks will resume as the economy transitions through the damage of the pandemic.
Jerome Powell stated, "The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test," He added that while inflation is solidly around the Fed's 2% target rate, "we have much ground to cover to reach maximum employment," which is the second prong of the central bank's dual mandate and necessary before rate hikes happen.
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The Fed looks at employment and inflation as benchmarks for when it will start tightening. Powell said that the "test has been met" for inflation while there "has also been clear progress toward maximum employment." He said he and his fellow officials agreed at the July Federal Open Market Committee meeting that "it could be appropriate to start reducing the pace of asset purchases this year."
The Fed committed to full and inclusive employment even if it meant allowing inflation to run hot for a while. "Today, with substantial slack remaining in the labor market and the pandemic continuing, such a mistake could be particularly harmful." "We know that extended periods of unemployment can mean lasting harm to workers and to the productive capacity of the economy."
Powell noted that the delta variant of Covid "presents a near-term risk" to getting back to full employment. Still, he insisted that "the prospects are good for continued progress toward maximum employment." "Inflation at these levels is, of course, a cause for concern. But that concern is tempered by a number of factors that suggest that these elevated readings are likely to prove temporary," he said.
Consumer Price Index (CPI)
The Consumer Price Index (CPI) readings will become even more important moving forward and have directly impacted market movements and overall sentiment. These CPI reports are becoming more significant as these readings are used to identify periods of inflation. More robust CPI readings will significantly influence the Federal Reserve's monetary policies and downstream interest rate hikes. The Federal Reserve is reaching an inflection point to where they will need to curtail their stimulative easy monetary policies as inflation, unemployment, and overall economy continue to improve. Inevitably, their long-term monetary policy of low-interest rates and bond purchases will need to pivot to a scenario of higher rates to tame inflation. As a result, investors can expect increased volatility as these critically important CPI reports continue to be released through the remainder of 2021. Additionally, any notion of higher rates may spur investors to reduce exposure to equities.
The CPI is an important economic readout as this is a measure of price changes of a basket of consumer goods and services used to identify periods of inflation. Mild inflation can encourage economic growth and stimulate business investment and expansion. High inflation reduces the buying power of the dollar and can reduce demand for goods and services. High inflation also drives interest rates higher while driving bond prices lower. By comparing the current cost of buying a basket of goods with the cost of buying the same basket a year ago provides an indication of changes in the cost of living. Thus, the CPI figure attempts to measure the rate of increase or decrease in a broad range of prices (i.e., food, housing, transportation, medical care, clothing, electricity, entertainment, and services). As CPI numbers catch fire and remain elevated, the Federal Reserve will need to act to tame any runaway inflation, especially in a red-hot economic expansion that we've witnesses post-pandemic.
Tapering is in the cards between now and the end of 2021. It's going to be a tug-a-war between inflation, employment, and the delta variant backdrop. CPI reports will become more significant as these readings are used to identify periods of inflation. The recent CPI readings are resulting in a much stronger influence on the Federal Reserve's monetary policies hence the taper guidance. Investors speculate on when, not if the Federal Reserve will curtail their stimulative easy monetary as inflation, unemployment, and the overall economy continues to improve. Inevitably, low-interest rates will not be here indefinitely, and bond purchases will need to subside, thus pivoting to a scenario of higher rates in the intermediate-term. As investors grapple with the prospect of downstream rate increases, pockets of vulnerabilities throughout the market will be exposed when rate hikes are deemed on the horizon. As real inflation enters the fray, these frothy markets will come under pressure and possibly derail this raging bull market and introduce some systemic risk in the process. Thus, investors can expect increased volatility as a function of critical economic data, specifically the CPI readings.
Despite this potential macro-negative backdrop for equity exposure, the banks are far stronger than during the 2008 Financial Crisis and have rigorous annual stress tests to show they can survive an economic downturn while maintaining the ability to make loans and continue paying out dividends. Moreover, the banks are much more resilient and capitalized and have demonstrated their ability to evolve in the face of COVID-19. As a result, the big banks present compelling value, especially with the prospect of rising rates; this may serve as a long-term tailwind for banks to appreciate higher.
Disclosure: The author holds shares in AAPL, AMZN, DIA, GOOGL, JPM, MSFT, QQQ, SPY, and USO. However, he may engage in options trading in any of the underlying securities. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of www.stockoptionsdad.com where options are a bet on where stocks won’t go, not where they will. Where high probability options trading for consistent income and risk mitigation thrives in both bull and bear markets. For more engaging, short duration options based content, visit stockoptionsdad’s YouTube channel.