On Thursday, June 20, all hell broke loose. The S&P 500 plummeted 2.5 percent, the NASDAQ declined 2.28 percent, and the Dow Jones Industrial Average fell 2.34 percent, extending the worst two day sell-off this year. Precious metals were crushed as the price of gold fell 7 percent and the price of silver tumbled 9 percent. Other commodities were also hit, with WTI oil prices declining 3 percent and natural gas prices falling 2 percent. Inversely, bond yields also soared, with the 10-year Treasury note climbing to 2.42%, the highest level since August 2011; almost every major bond market across the world was also hit with a yield spike.
Although there were a variety of factors that contributed to the huge sell-off, such as weakening manufacturing growth and credit tightening in China, widespread fears of a slowdown of the Federal Reserve’s quantitative easing program provided the main impetus for the market spiral. In his remarks on Wednesday, Federal Reserve Chairman Ben Bernanke stated that if the economy continues to recover, the Federal Reserve would consider slowing down, or “tapering” its purchasing of bonds (quantitative easing) as early as this fall. Moreover, he noted that the Federal Reserve plans to stop buying new bonds when unemployment falls to 7 percent.
Quantitative easing played a large part in the stock market’s recent rallies through keeping interest rates low, which in turn encouraged investors to borrow and move into riskier assets such as stocks. Thus, investors are getting jittery about tapering, fearing increasing market volatility and pessimism as a major cushion is being pulled out from under their legs. In the Wednesday conference, many saw their fears of a quantitative easing draw-down substantiated and subsequently started indiscriminately selling as if it were the end of the world.
In such doom and gloom, a key sector stands out as a potential beneficiary of the tapering and eventual end of quantitative easing: banks such as JPMorgan Chase & Co. (NYSE:JPM), Citigroup Inc. (NYSE:C), and Wells Fargo & Co (NYSE:WFC).
Much of a bank’s earnings growth is derived from something called net interest margin, which is the difference between how much a bank can charge for loans and how much it gives out for deposits. As noted by Steve Baden, the president of the Royal Banks of Missouri, “the three key measurements [in banking] are net interest margin, efficiency ratio and return on equity — everything else is poppycock.”
This net interest margin has been significantly hit by the Federal Reserve’s quantitative easing, which pushes down interest rates and in turn allows banks less room for profit. Net interest margin has been extremely low for the past few years, impacting the entire sector. According to The Wall Street Journal, the average margin for the industry’s largest banks in late 2012 was 3.12 percent, the lowest since the second quarter of 2009. Before the Federal Reserve enacted quantitative easing, banks were used to healthy margins of 4 to 5 percent. The net interest margin for all U.S. banks currently stands at 3.21 percent and continues to trend downward:
The mega-banks generally have more diverse revenue streams than regional banks such as Regions Financial Corporation (NYSE:RF) and Huntington Bancshares Incorporated (NASDAQ:HBAN). These two particular banks are especially sensitive to interest rate changes, as noted by a recent Merrill Lynch report. Regional banks often rely on traditional loan deposits for a much greater percentage of their revenues but the tapering of quantitative easing will significantly benefit both regional and national banks.
For example, Citigroup Inc. (NYSE:C) generates around 30% of its revenue from Consumer Banking and Wells Fargo & Co (NYSE:WFC) generates 22% of its revenue through Loans. Jamie Dimon of JPMorgan Chase & Co. (NYSE:JPM) has even stated in his annual letter to shareholders, “As we currently are positioned, if rates went up 300 basis points, our pre-tax profits would increase by approximately $5 billion over a one-year period.” Although revenue from the net interest margin doesn’t account for a vast majority of the revenue of these big banks, it still matters a lot.