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Wells Fargo & Co (WFC), Bank of America Corp (BAC) & More: Worried About Rising Rates? Make This ‘Hated’ Sector Work For You

A few years ago, bank stocks were among the most unloved investments. Many of them traded well below book value and also sported low price-to-earnings multiples. Yet a pair of factors has led investors to rapidly warm up to bank stocks.

First, the global economic crisis no longer seems to be a mortal threat to bank’s balance sheets. A long-anticipated crisis simply never came to pass. Second, a sense that the U.S. housing market — a key source of bank profits — was on the mend, has led to expectations of a brightening profit forecast.

Indeed, second-quarter results are in from the major banks, and they look quite solid.

A Solid Quarter For Leading Banks

As a result, after a 20% surge in the first half of this year (compared with a 13% gain for the S&P 500), bank stocks have rallied further in the early weeks of the third quarter. This continues a trend that has been underway for nearly two years.

Yet behind the scenes, there are several moving parts that might either derail the bank rally, or push these stocks even higher. Here are five key issues that may affect this group over the next few years.

1. Rising Interest Rates

Over the next few years, economists expect interest rates to start moving higher. “Long rates,” such as the yield on the 10-year Treasury, are dictated economic sentiment, and as the economy strengthens, these yields are expected to rise from a current 2.55% toward the 4% level.

“Short rates,” which are pegged to the federal funds rate (the Federal Reserve’s benchmark interbank lending rate), are not expected to start rising for at least a few more years. (The Fed wants to see unemployment at 6.5% before rates are hiked, as I discussed in a previous column.)

For banks, such a scenario will be a headwind before it becomes a tailwind. Over the next few quarters, banks are expected to suffer from net interest margin compression, which means their profit spreads on loans will narrow as their own short-term borrowing costs rise faster than the average rate of loans they have issued to clients.

Over the longer term, banks start to make up for lost time, as a firming economy means they can charge higher interest rates (relative to their own borrowing costs). Indeed, “net interest margin expansion” is a phrase you may be hearing a lot more in 2014 and 2015.

2. Reduced Refinancing Activity

Banks have benefited handsomely from the multi-year phase of mortgage refinancings. As homeowners locked in lower mortgage rates, they paid out lots of fees to banks, most of which are pure profit. Yet the recent increase in the 30-year mortgage rate to 4.35% (from 3.35% just a quarter ago) has already led to a slowdown in refinancings.

If mortgage rates rise higher in coming quarters, then this high-margin source of revenue will slow even more. Many of the major banks noted this concern on their recent quarterly conference calls, and the coming months will give a clearer read on whether the era of refinancing has officially come to an end.

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