Skip to main content

Inside the Market Expected rate cuts could help revitalize Canadian and U.S. bank stocks

U.S. and Canadian bank stocks have been struggling over the past year, but there’s some historical evidence that looming interest-rate cuts by central banks will give the sector a much-needed boost.

Indeed, if banks on both sides of the border follow the path of previous rate-cutting years over the past two decades, double-digit gains could be coming.

“Based upon the prior cycles, 1995-98 and 2001-03, [U.S.] bank stocks outperformed the S&P 500. From the time the Fed cut the federal funds rates to the peak in bank stock prices, bank stocks outperformed the S&P 500 by 6,900 basis points in 1995-98 and 2,700 basis points in 2001-03,” Gerard Cassidy, an analyst at RBC Dominion Securities, said in a note.

Story continues below advertisement

Canadian banks also performed well during these periods.

Any rebound would be nice. The U.S. KBW Banks Index is down 6 per cent over the past year, which adds to the importance of second-quarter financial results from Citigroup Inc., JPMorgan Chase & Co., Goldman Sachs Group Inc., Wells Fargo & Co. and Morgan Stanley this week.

Canadian commercial banks, which will report their quarterly results in August, haven’t fared much better: They’re down 1.9 per cent over the past year, marking a relatively rare period when banks have underperformed the S&P/TSX Composite Index.

There are plenty of headwinds facing the sector, from trade tensions and concerns about the slowing global economy. In Canada, mortgage growth has slowed to a crawl amid weak home-sales activity in Vancouver and Toronto.

But the yield curve, which is the difference between the yields on long-term and short-term government bonds, is a particularly strong source of concern. Three-month Government of Canada bonds are yielding more than 10-year bonds, which is an unusual event known as a yield-curve inversion. The U.S. yield curve inverted earlier this year, pointing to a potential recession ahead.

This isn’t good for banks. Since banks borrow at short term rates (in the form of deposits) and lend at longer-term rates, even a flat yield curve means that margins on loans get compressed, which weighs on bank profitability.

No wonder stock valuations are cheap. Canadian banks trade at just 11-times earnings, according to Bloomberg. That’s well below the 10-year average price-to-earnings ratio of 12.3. U.S. bank valuations are also low: The KBW Banks Index has a P/E of 11.1, which is below the 10-year average of 13.5.

Story continues below advertisement

The hope for investors: Financial markets expect that the U.S. Federal Reserve will cut interest rates, perhaps this month, to stimulate economic activity.

If all goes well, the cuts will drive down short-term bond yields and steepen the yield curve – raising bank profits on loans and keeping the economic expansion alive. It’s a reasonable bet that the Bank of Canada will follow the Fed’s lead later this year with rate cuts of its own.

Mr. Cassidy argued in a note on Friday that two eras of previous rate cuts offer a useful template.

Between July, 1995, and November, 1998, the Fed cut its key rate six times, sending the KBW Index up 136 per cent over the same period (not including dividends). Bank stocks outperformed the broader S&P 500 by 31 percentage points, according to Bloomberg.

Canadian bank stocks also responded (the Bank of Canada cut rates during this period, too): The stocks rose 111.4 per cent, or nearly three times the increase for the S&P/TSX Composite Index.

The Fed cut rates during the dot-com fuelled a downturn as well, between January, 2001, and June, 2003. Bank stocks took a little longer to respond. But the KBW Index rose 68 per cent between September, 2002, and March, 2004, and Canadian banks rose 57 per cent, outperforming their respective indexes.

Story continues below advertisement

Okay, the Fed also cut interest rates in 2007, during the opening stages of the financial crisis – when buying bank stocks was a quick way to lose piles of money. But Mr. Cassidy makes a distinction with this rate-cutting era.

“Though we hesitate to say ‘this time is different,’ the Fed waited too long to cut rates in 2007-08 and the down leg of the credit cycle overwhelmed the benefit of federal funds rates cuts and the steepening of the yield curve, in our view,” he said in his note.

The bullish bet is that the Fed will cut its key rate this month, reminding some investors that the mid-1990s were good years.

Report an error Editorial code of conduct
Due to technical reasons, we have temporarily removed commenting from our articles. We hope to have this fixed soon. Thank you for your patience. If you are looking to give feedback on our new site, please send it along to feedback@globeandmail.com. If you want to write a letter to the editor, please forward to letters@globeandmail.com.

Welcome to The Globe and Mail’s comment community. This is a space where subscribers can engage with each other and Globe staff. Non-subscribers can read and sort comments but will not be able to engage with them in any way. Click here to subscribe.

If you would like to write a letter to the editor, please forward it to letters@globeandmail.com. Readers can also interact with The Globe on Facebook and Twitter .

Welcome to The Globe and Mail’s comment community. This is a space where subscribers can engage with each other and Globe staff. Non-subscribers can read and sort comments but will not be able to engage with them in any way. Click here to subscribe.

If you would like to write a letter to the editor, please forward it to letters@globeandmail.com. Readers can also interact with The Globe on Facebook and Twitter .

Welcome to The Globe and Mail’s comment community. This is a space where subscribers can engage with each other and Globe staff.

We aim to create a safe and valuable space for discussion and debate. That means:

  • Treat others as you wish to be treated
  • Criticize ideas, not people
  • Stay on topic
  • Avoid the use of toxic and offensive language
  • Flag bad behaviour

Comments that violate our community guidelines will be removed.

Read our community guidelines here

Discussion loading ...

Cannabis pro newsletter