It’s a headwind that will certainly impact Citigroup (NYSE:C) and Wells Fargo (NYSE:WFC) as much as it does Bank of America (NYSE:BAC). But BAC stock was the only major bank stock Raymond James analyst Michael Rose downgraded last week in response to falling interest rates, and more recently, inverted yield curves.
“We see waning prospects for the company to generate positive operating leverage next year,” wrote Rose to explain the downgrade. He further explained “Pressure for the bank sector is coming from several angles. The U.S. economy remains relatively healthy but we have begun to see some signs of deterioration.” Ultimately, Raymond James cut its rating on Bank of America stock to “market perform,” down from “outperform.”
The thesis holds water, though it may have been voiced well after the market realized the risk.
Falling Rates Weigh Down BAC Stock
The market had already started to downgrade BofA shares early last year, without any real prodding from analysts. That’s when the BAC stock price fell from the March 2018 peak near $33 to a low of less than $23 by December. Shares bounced, but only temporarily, falling back to their current price of just under $28.
Worries about falling interest rates, which crimp bank profits, expanded during that timeframe for good reason: rates were falling for most of it. The yield on 10-year Treasuries peaked at 3.23% in October of last year. They have since plunged to their current level of 1.47%. Those worries were further legitimized in this year June, with the Federal Reserve cutting interest rates by 25 basis points. This was the first rate cut in over ten years.
However, it’s not the past that concerns Raymond James’ Rose as much as it is the likely future. Rose’s comments further noted “We now see its greater than peer asset sensitivity positing a greater challenge to net interest income given further flattening of the yield curve and the potential for several additional rate cuts from here.”
The yield curve first inverted in mid-August, when yields on 10-year bonds fell to 1.574%. That move sent it below the yield on two-year notes, suggesting a possible recession on the horizon. Although this inversion reversed shortly thereafter, its re-materialized this past week when the 10-year Treasury yield slipped to 1.47%. This was below the yield of 1.5% on two-year notes. The yield on 30-year Treasuries also slumped to a record-low 1.9% last week.
The inversion could persist for a while, now that it’s being established.
Company-Specific Headwinds Worry Some Investors
Rose’s analysis acknowledges the changing interest rate environment is problematic for all banking names. “While the debate will certainly continue to rage around how many Fed rate cuts we get from here and how low yields will ultimately go,” he notes, “at a minimum, it stands as a significant earnings headwind for the majority of banks and the industry.”
Rose is specifically concerned about “banks’ willingness to continue to lend at relatively thin (and declining) spreads.”
Lower interest rates make the lending business less profitable, as measured by margins. This is the difference between what interest rates a bank can charge, and what it costs the bank to borrow that capital.
But Rose arguably singled out Bank of America stock for good reason. He pointed out BofA’s “greater than peer asset sensitivity positing.”
The explanation was a nod to a nuance that makes Bank of America notably different than other banks. It services an unusually large number of non-interest-bearing deposits. That’s a boon when rates are on the rise but is problematic when rates are falling.
The company itself had already dropped similar hints about its exaggerated sensitivity to interest rate changes. In April of this year, CFO Paul Donofrio cautioned current and would-be owners of BAC stock that this year’s net interest income growth would only be about half of last year’s 6% pace. Donofrio further warned in July that the growth pace could slow to as weak as 1% if the Fed imposes more than the one rate cut it’s already made.
Though the Fed doesn’t appear to be in a hurry to cut rates again when it will have a chance to in mid-September, interest rate futures suggest there’s a 95.8% chance the Fed funds rate will fall by another quarter of a percentage point.
Looking Ahead for Bank of America Stock
Though Raymond James is waving a red flag, note that it’s not an outright “sell” recommendation. Indeed, the consensus rating on BAC stock is still closer to a “buy” than a “hold.” Moreover, the consensus BAC stock price target of $33.29 remains well above the equity’s present price near $27.50. It’s important to not read too much into the downgrade.
The worst-case scenario may already be priced in.
Still, that collective confidence that Bank of America will keep pace with the market may not yet reflect the possibility for things to get even worse. If a full-blown recession is in the cards, that would crimp demand for loans regardless of how strong or weak margins are on them. That could alter the discussion surrounding Bank of America dramatically, for the worse.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities. You can learn more about him at his website jamesbrumley.com, or follow him on Twitter, at @jbrumley.