The banks can suffer when longer-term interest rates are only slightly above short-term interest rates. But they can offset this by expanding their businesses, particularly with higher-yielding assets. So the big five banks remain buys, especially as they’re bargain stocks for value investors to buy now.
Some central banks are experimenting with what’s known as ‘negative yields’. That is, commercial banks will lose a little of the money they deposit with these central banks.
The idea is that negative yields will drive commercial banks to yank money out of the central banks. The commercial banks are better off lending to credit-worthy customers and making money.
The negative yields are modest. The European Central Bank looks after the 19 nations of the euro zone. It charges commercial banks 0.3 per cent a year on money they deposit with it. The central banks of Denmark and Switzerland charge 0.75 per cent. The central bank of Sweden charges the most—1.25 per cent. On January 29, Japan began to charge 0.1 per cent—the lowest negative yield.
Possible, but not likely, in Canada
There’s a possibility that negative interest rates could spread to Canada. Bank of Canada governor Stephen Poloz mused in a speech that a negative yield of 0.5 per cent is possible. But he said that this would require “another major shock” to the economy. We hope that investment in infrastructure by the federal government will get the Canadian economy moving ahead more quickly.
So far, foreign commercial banks facing negative yields have absorbed the costs. But eventually, they might start charging their customers for their bank deposits. At that point, some customers may open a safe-deposit box and stuff cash into it. The cash would earn nothing. Then again, no erosion of its value would take place—except for the impact of inflation.
Fortunately, this is not the case in Canada. The big five banks can keep all of their money for the benefit of their shareholders.
Canadian banks do, however, face flat yields over shorter terms of the yield curve. Currently one-month yields are only marginally lower than five-year yields. This is negative for the banks. That’s because they borrow at the short end from, say, savings accounts. They then lend for longer terms for, say, five-year mortgages. As a result, their net interest income partly reflects the spread between short-term and longer-term interest rates.
The spread matters, but so do volumes
It’s best for the banks when short-term interest rates are significantly below longer-term interest rates. That’s because they pay little on savings accounts. At the same time, the banks can earn meaningful interest from five-year mortgages. The wider this spread, the better.
Today’s flat yield curve over the first five years is expected to hurt the banks’ profits. This may explain why their share prices have fallen. But Bank of Montreal has just reported its results for the first quarter of fiscal 2016 and it fared relatively well.
In the three months to January 31, Bank of Montreal earned net interest income of $2.480 billion. That is, it generated that amount more on its assets (such as mortgages) than it paid on its liabilities (such as savings accounts). This was up by 14.5 per cent from $2.165 billion a year earlier. The bank writes that it “benefited from the acquired BMO Transportation Finance business”. That is, Bank of Montreal profited from doing a larger volume of higher-interest financing.
All of the big five banks have acquired businesses sold by other companies, such as parts of General Electric’s financial business. They’ve also bought credit card portfolios on which they can charge high interest on outstanding balances. And even when consumers wisely pay off their balances in full each month, the banks can earn transaction fees from their purchases.
In the three months to January 31, Bank of Montreal earned an adjusted $1.178 billion. This was up by 13 per cent. Thanks to share buybacks, its adjusted earnings per share climbed by an even better 14 per cent.
When others panic and dump high-quality stocks such as the big five banks, you should buy. Then you can earn attractive and growing dividends as well as long-term share price gains.
Rates will stay low
Low interest rates can hurt banks. But as we said above, Bank of Montreal has taken low interest rates in stride. Besides, its non-interest revenue of $2.595 billion exceeds its net interest income of $2.480 billion.
We predicted that U.S. rates would pause in our January 4 issue. We wrote, “When will the Fed increase interest rates further? About 62 per cent of Wall Street experts expect another increase in the first quarter of 2016. We disagree. Our view is that the Fed will not raise U.S. interest rates in the first quarter.”
We noted that higher interest rates would further raise the value of the U.S. dollar. This would disadvantage American exports. It would also reduce the value of sales and earnings in foreign currencies. With tame inflation, there’s no need to raise interest rates soon.
The Investment Reporter, MPL Communications Inc.
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