By Chase Nerison
Jerome Powell and the Federal Reserve Bank have been a hot topic recently as they determine the course of action for the federal funds rate and discount rate, which impacts overall interest rates. During this bumpy period, Powell’s future was uncertain as his term expires in the beginning of 2022, but most analysts predict he will serve a second term as chairman of the Fed. Briefly, the federal funds rate is the rate banks charge other institutions for lending excess cash from their reserve balances to meet overnight reserve level requirements, and the discount rate is the rate the Federal Reserve charges banks that borrow from it directly. Banks set their own interest rates when borrowing from other banks but stay within the target federal funds rate. Since the Fed wanted to stimulate economic growth due to the pandemic, interest rates have been extremely low as shown in the chart. After finally rallying from the necessarily low interest rates surrounding the Great Recession, rates were cut once again.
Decreasing interest rates “makes money cheap” as this encourages spending and investment. With more spending money, consumers will increase borrowing and purchasing of large items. This decrease in interest rates significantly helps the economy, but there are reasons why interest rates must find an equilibrium and not always stay extremely low. With lower rates, inflation and liquidity traps are common problems. Due to this economic stimulation, inflation is over 4% in 2021, which is twice as high as the Fed’s 2% target. With this concern, many anticipate an increase in interest rates most likely in the beginning of 2022 and almost without a doubt in 2023 and 2024. As we look towards the future with these interest rate increases, this will affect the economy, especially financial institutions. Specifically, Investment Banks will be eager to see rising interest rates.
Before getting into interest rates affecting investment banks, it is important to understand the current environment of the U.S. economy. In an article by James Montier and Philip Pilkington, members of GMO’s Asset Allocation Team, titled “Inflation Tall Tales and True Causes,” the two discuss the credibility behind inflationary fears. Rather than simple-minded explanations, inflation is a cumulative process with a feedback loop between prices and costs. When examining inflation and its likelihood of embedding itself in the system, labor costs are key. Without a material change in labor’s bargaining power, it is very unlikely to stay. Additionally, consumer spending saw an uptick due to government stimulus checks increasing the money supply, but we are seeing it come back at this moment, slowing down to 2% growth in Q3 from its previous 6.7%. Thus, I agree with the authors in that this inflationary angst is likely misleading and will not impact the future, but it will be worth following labor prices and employee walkouts as seen recently in General Electric, John Deere, and more.
Despite the steadily growing economy since the 2008 financial crisis, most corporate and investment banks (CIBs) have not fully recovered due to tighter regulation, unfavorable interest rates, and high costs. If interest rates rise as expected in 2022, we will see CIBs succeed. Financial institutions like retail banks, commercial banks, investment banks, insurance companies, and brokerages hold large amounts of cash due to regulation, customer balances, and business activities. With this potential increase in interest rates, the yield on this cash will increase, which goes straight to earnings. In comparison, think of oil prices rising for oil drillers. Many investment banks will see increased profit from their sales and trading division as brokerages also succeed with this change. For other banks, this increase in interest rates signals a stronger economy which means more consumers seeking loans. This allows banks to benefit from the difference between the interest they charge investors for the loan and the amount they earn from investing. To successfully manage these interest rates, most banks will borrow on a short-term basis and lend on a long-term basis to allow flexibility.
Many financial institutions benefit from increased interest rates, and investment banks are one of those beneficiaries. These big investment banks provide many services including asset management. Specifically, Morgan Stanley is an iconic name in the space as they have more than $1.1 trillion in total assets. Any material rise in interest rates creates the opportunity to place idle cash in low-risk bonds. Additionally, this will create more volatility in the market, so wall street will reshuffle its priorities. Increased rates are typically a sign of a healthy economy which means more investment activity and brokerages benefit from increased interest income. For top-tier investment banks, their intelligent managers can cash in on the best investments during this shift.
Going back to the fundamentals of monetary policy, increasing interest rates “makes money expensive.” Since borrowing is more expensive, it is quite possible to see an increase in equity issuing. Clearly, this would benefit investment banks as they assist with stock and bond offerings. With more difficulty on the consumer side, IBs should also show bigger margins and more profits. Even though interest rate changes have not taken place yet, there are still banks increasing fees like UBS as their third-quarter earnings saw a major boost. To additionally aid higher profit, fast-growing economies boost merger activity. The graphs below illustrate this correlation.
Due to the impact and volatility of interest rates, investment banks must hedge to account for interest rate risk. Representing one of the biggest market risks, interest rate exposure is prevalent throughout firms in trading activities, issuing debt, their investment securities portfolio, and more. Goldman Sachs defines interest rate risk as results from exposures to changes in the level, slope and curvature of yield curves, the volatilities of interest rates, prepayment speeds and credit spreads. A common fair value hedge is interest rate swaps. Like one would expect, a swap is an exchange of sets of future cash flows and forward rate agreements (FRAs). The most common interest rate swap is called a plain vanilla swap when one party pays a fixed interest rate and receives a floating rate and vice versa. After researching how Goldman Sachs, Morgan Stanley, and JP Morgan Chase handle interest rate risk through their 10-Ks and 10-Qs, most firms apply a statistical method that utilizes regression analysis to determine the effectiveness of the fair values and risk being hedged. JP Morgan uses earnings-at-risk scenarios to estimate the potential change to net interest income over the following 12 months utilizing a variety of shifts and scenarios.
Lastly, this article would not be complete without advice to the retail investor if interest rates increase. First, these higher interest rates will hurt most stocks as earnings decrease. I advise investing in value stocks rather than growth stocks as debt is more costly. Financial institutions like commercial and investment banks should also perform well. Second, reduce long-term bond allocation. If you invest in bonds, consider a laddering strategy, which contains a portfolio of individual bonds with different maturities. This strategy provides current income while lowering interest rate exposure. Finally, I would suggest selling any typical inflationary hedges. Once you have your fixed-income portfolio accounting for rising interest rates, consumer discretionary stocks should see a bump in a healthy economy but be careful with travel-related stocks currently with the pandemic.
With so many factors affected by interest rates in corporate and investment banking, this is why the Fed’s activity is important. The Fed has to keep inflation, unemployment, monetary policy, and the strength of the economy in mind at all times as they set the federal funds rate and discount rate 8 times a year. These rates directly affect the profitability of all companies- a reason why interest rate risk is significant. As we look towards the future with a possible increase in interest rates in 2022, I hope this knowledge is applied to understand interest rates and their effect on corporate and investment banking.
Works Cited
Awoye, J. (2021, March 12). Here are some moves to consider during a period of rising interest rates. CNBC. Retrieved October 24, 2021, from https://www.cnbc.com/2021/03/12/some-moves-to-consider-during-a-period-of-rising-interest-rates.html.
Bartash, J. (2021, September 22). Fed 'dot plot' signals higher U.S. interest rates in 2022, but Powell warns it's not set in stone. MarketWatch. Retrieved October 24, 2021, from https://www.marketwatch.com/story/fed-dot-plot-signals-higher-u-s-interest-rates-in-2022-but-powell-warns-its-not-set-in-stone-11632337181.
Boulay, G. L., et. Al. (2021, April 1). Reinventing corporate and Investment Banks. BCG Global. Retrieved October 24, 2021, from https://www.bcg.com/publications/2020/reinventing-corporate-investment-banks.
Hall, M. (2021, July 3). What affect do interest rates have on banking profitability? Investopedia. Retrieved October 24, 2021, from https://www.investopedia.com/ask/answers/041015/how-do-interest-rate-changes-affect-profitability-banking-sector.asp.
Montier, J., & Pilkington, P. (2021, August). Part 1: Inflation – tall tales and true causes. GMO LLC. Retrieved October 25, 2021, from https://www.gmo.com/americas/research-library/part-1-inflation--tall-tales-and-true-causes/.
Norris, E. (2021, October 24). Managing interest rate risk. Investopedia. Retrieved October 24, 2021, from https://www.investopedia.com/articles/optioninvestor/08/manage-interest-rate-risk.asp.
Reeves, J. (2021, September 30). 10 best stocks for rising interest rates. Kiplinger. Retrieved October 24, 2021, from https://www.kiplinger.com/investing/stocks/603542/best-stocks-for-rising-interest-rates.
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