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Morningstar | Fed Tightens Again but Provides a More Dovish Tone Regarding Future Rate Hikes

While the rate hike outlook has become more uncertain over the past several months, it was still largely expected that the Federal Open Market Committee would raise its target rate at its December meeting. The FOMC did not disappoint and voted to raise its target rate range to 2.25%-2.5%. The vote was unanimous. There was again a slight change in the language of the release as well as a more dovish looking dot plot. The FOMC’s statement maintained its language that further hikes would be gradual and that the risk outlook remains roughly balanced; however, the committee replaced the word “expects” with “judges” when describing how it thought about the effect of these further gradual rate hikes on the economy and inflation. This, combined with additional language about continuing to monitor global economic and financial developments (which was also not in the previous release), leads us to conclude the Fed is giving a nod to some of the uncertainty regarding the economy and the effects of future hikes and is leaving the door open to slow down future rate increases. Further confirming this more dovish tilt, the dot plot also shifted, with many of the higher rate dots shifting down, creating a lower projected median rate. The 2019 median projected rate is now 2.9%, down from the 3.1% rate given at the September meeting, and the longer run median rate is now projected at 2.8%, down from 3.0%. CME futures data further reflects this shift, and is in fact even more dovish than the Fed, with the highest probability given to zero rate hikes in 2019. Overall, our long-term rate projection remains intact, where we expect a normalized policy rate of roughly 2.75% to be reached in the next couple years. We would expect overall net interest margins to increase at a reduced pace regardless, as competition picks up among banks. We are leaving current fair value estimates in place for all our banks.

Economic data remained positive for the U.S., with unemployment remaining quite low, household spending and business investment remaining constructive, and real GDP growth expected to be 3% for 2018. Further, core-PCE measures remained roughly in line the Fed’s 2% target, taking away any pressure to raise rates due to runaway inflation for the time being.

The most rate-sensitive names we cover are Comerica, Cullen/Frost, and M&T, with Comerica being the clear standout with roughly 90% of its loan book being variable rate. We will remind investors that sensitivity to interest rates works both ways, with high leverage and increasing returns on the way up, but also more room to fall if rates were to decrease for an extended period of time again. With the sell-off of the banking sector over the last couple months, more names among the banks are beginning to look slightly undervalued. We believe the market largely understands the rate plays, and we tend to view names with more idiosyncratic stories as the most undervalued. This includes Wells Fargo, Citi, Capital One, and KeyCorp. This is in stark contrast to the start of the year, where we largely viewed the banks as being on the high end of fairly valued to even overvalued (with many trading at 2 stars).

For a more detailed view of our expectations regarding interest rates and their effects on banking profitability, please see our December 2018 Observer, "The Return of the Bank: Net Interest Margins Reach a Turning Point--Funding Advantages and Net Interest Income."