Do bank stocks go up when interest rates rise?

Interest rates, set by the Federal Reserve (aka “the Fed”), have widespread economic influence. When the Fed changes rates, it affects the cost of borrowing, investment decisions, savings returns, housing markets, bond prices, currency values, stock prices and overall economic activity. If you have tried to get a mortgage in the past year, you have seen just how significant those effects can be. 

To curb inflation, the Fed has raised the short-term interest rates to over 5% (from nearly zero in the first quarter of 2022). This has made borrowing more expensive and reduced spending and investing, which has helped cool down our overheating economy. However, banks have passed along those extra borrowing costs to their consumers through loans like mortgages.

The question on investors' minds is: Do bank stocks go up when interest rates rise? And do bank stocks do well when interest rates rise?

The answers are more complex than you might think. Keep reading to understand how bank stocks perform as interest rates increase and how you can strategically position your portfolio to capitalize on the opportunities and mitigate risks that a rising rate environment presents.

The interest rate-bank stock connection

While the historical correlation between interest rates and bank stocks is complex and varied, the consensus is that rising interest rates benefit banks. Let's take a look at some economic theories that help explain why: 

• Net interest margin (NIM) expansion: Banks make money by borrowing at lower short-term interest rates and lending at higher long-term interest rates. When interest rates rise, the spread between the rates at which banks borrow and lend money widens, leading to an increase in their NIM. It can enhance the profitability of banks.
• Interest income growth: Rising interest rates can lead to higher interest income for banks, particularly if they have a significant portion of their assets in loans with variable interest rates. As interest rates increase, the interest payments on these loans also rise, contributing to higher overall income for the banks.
• Asset-liability mismatch: Banks often have a mix of short-term and long-term assets and liabilities. Rising interest rates can be advantageous if a bank's assets (such as loans) have longer durations than its liabilities (such as deposits). As interest rates increase, the interest earned on long-term assets outpaces the interest paid on short-term liabilities.
• Improved loan pricing: Higher rates can lead to more favorable loan pricing for banks. When interest rates rise, banks may charge higher interest rates on new loans, which can positively impact their profitability. This assumes that the increase in loan interest rates is greater than the increase in the cost of funds.
• Strengthened balance sheets: Rising interest rates can positively impact the overall health of the economy. A stronger economy often leads to reduced credit risk, resulting in lower default rates on bank loans. In turn, this strengthens balance sheets and improves the quality of their assets.
• Encouragement of savings: Higher interest rates can incentivize individuals to save more money. This benefits banks as they attract more deposits, providing them with additional funds to lend and invest.

But it's not all sunshine and roses. Interest rate risk becomes a concern when a bank's liabilities mature more quickly than its assets, potentially leading to a compression of NIMs. Higher interest rates can also dampen loan demand, affecting the growth of a bank's loan portfolio. The impact on asset valuation is another consideration, as the market value of fixed-rate securities in a bank's portfolio may decrease with rising rates, potentially leading to losses if these securities are sold before maturity. 

Economic slowdowns associated with interest rate hikes can result in higher loan default rates, adversely affecting the quality of a bank's loan portfolio. Investor sentiment also plays a crucial role, and if rising interest rates threaten economic growth or bank profitability, it can lead to a sell-off of bank stocks in the market. 

Factors influencing bank stock performance

Understanding why and how bank stocks respond to interest rate changes is crucial for investors navigating this market segment. Some specific areas to pay special attention to include:

• Regulatory environment: Stringent regulations may limit a bank's ability to capitalize on rising interest rates or navigate economic fluctuations. Compliance costs associated with regulatory changes can also impact a bank's profitability, influencing its stock performance.
• Monetary policy: When central banks raise rates to curb inflation, it benefits banks by expanding NIMs. Conversely, accommodative policies can lower borrowing costs but may compress margins. The overall stance of monetary policy guides market expectations, influencing bank stocks.
• Macroeconomic conditions: During periods of economic expansion, banks typically experience increased loan demand, positively impacting interest income and overall profitability. Conversely, economic contractions may lead to higher default rates, negatively affecting the quality of a bank's loan portfolio and its stock performance.
• Inflation: Central banks often adjust rates in response to inflation trends. While moderate inflation may be accommodative for banks, high or unpredictable inflation can erode the real value of loans, impacting profitability and potentially hindering stock performance.
• Loan demand: In a rising interest rate environment, borrowing costs may increase, potentially dampening loan demand. However, if interest rates rise due to a strong economy, increased demand for loans can offset the negative impact on NIMs, positively affecting bank stocks.
• Yield curve shape: A steepening yield curve, where long-term rates rise faster than short-term rates, generally benefits banks by enhancing NIMs. However, a flattening or inverted yield curve can signal economic challenges, potentially impacting bank profitability and stock prices.
• Borrower credit quality: Rising rates may increase the cost of servicing debt for borrowers, potentially leading to higher default rates. This, in turn, affects the quality of a bank's loan portfolio and can influence its stock performance.
• Cost of funds: If the cost of acquiring funds rises faster than the interest earned on loans, it can squeeze NIMs and negatively impact profitability, affecting stock prices.

The interest rate environment

The Federal Reserve Act of 1913 addressed systemic issues in the U.S. banking and financial system as a response to recurrent panics and economic downturns. The Act established a decentralized central bank, the Federal Reserve, which would supervise and stabilize the U.S. financial system by regulating the money supply and acting as a lender of last resort during economic stress. 

The Federal Reserve manages inflation, often measured by the Consumer Price Index (CPI), by adjusting interest rates. Raising rates will cool down the economy and reduce spending when inflation is a concern, and lowering rates will stimulate economic activity and prevent deflation when necessary. As such, the two tend to move in the same direction: when inflation is on the rise, expect interest rates to follow suit, and when the economy is in a downturn, expect rates to decrease. This ebb and flow of rates and inflation is a staple of America's economy for a long time. 

A great example of the Fed lowering interest rates to boost the economy is during the COVID-19 pandemic, which helped many businesses recover during economic uncertainty.

The relationship between interest rates and bank stocks

How do bank stocks perform during inflation? For example, the overall impact on a specific bank depends on individual circumstances–its asset and liability structure and risk management practices. But, as a general rule, bank stocks increase when interest rates rise as the financial institutions have potential to bring in more revenue. 

When you deposit into a bank account, a bank doesn't just hold onto it until you need it. Instead, it will lend that money to investors or individuals to generate income via the interest rates they charge on those loans. For that process to be profitable, banks must charge a higher interest rate on the loan than what you will receive on your savings account. 

When interest rates rise, it's common for loan rates to grow two or three times more than interest rates on money deposited, allowing the bank to increase its profit margin when rates go up. 

While the overall performance of bank stocks during inflation is good, this is not universal. For example, the higher the interest rate rises, the less people will be willing to take out loans. If loans dry up too much (if the lack of loans overshadows the increased profit margin), a bank might not meet the expected revenue, and, in this case, the stock would likely drop.

Investor strategies during rising interest rates

Before investing in bank stocks, you should carefully assess your risk tolerance and conduct due diligence on individual banks' balance sheets, risk management practices and the Fed rate hike stock market information.

Prioritize bank stocks with strong fundamentals, including solid balance sheets, efficient operations, and prudent risk management practices. Quality stocks may be more resilient during challenging economic conditions.  

A diversified investment approach can also help you mitigate risks and capitalize on opportunities presented during a rising interest rate environment. Consider diversifying geographically by including international bank stocks in your portfolio, as different regions may experience varying economic cycles and interest rate environments, providing a buffer against localized risks.

Staying informed about the banks in your portfolio and the current economic conditions is essential to good portfolio management. Conduct periodic portfolio reviews to ensure that the asset allocation aligns with changing economic conditions and adjust, if necessary. 

Keep abreast of economic indicators, central bank communications and global market trends. Actively monitor the performance of bank stocks and be prepared to make informed decisions based on new information.

Example of a bank stock in a rising interest rate environment

From January 2021 to November 2022, mortgage interest rates ballooned from near-record lows of around 3% to more than 7%. This time was volatile for many sectors, but it allows us to view real-world examples of bank stocks' performance when rates were skyrocketing.

With that said, the past performance of the stock market is never a guarantee of future results. With that in mind, let's look at how Bank of America NYSE: BAC performed during this period. 

Bank of America

Bank of America's stock chart from January 2021 through November 2022) is a great example of the ebb and flow bank stocks experience during times of rate increase. As you'll see from the chart, the stock began to perform well in late 2020 and experienced tremendous growth until October 2021, when it topped out at more than $48.

Following the prosperity of the early period of rate increases, the stock returned to earth for most of 2022 before a small rebound heading into November 2022. When rates flattened from November 2022 to April 2023, there was a decline to a regular stock price.

This stock is a perfect example of what we discussed in the section detailing the relationship between interest rates and bank stocks. When rates first started to rise, we saw the stock start to perform well, and you'll also see Bank of America's earnings topped out in the second quarter of 2021. 

Earnings were boosted by the increased profit margins we discussed earlier when the difference in loan rates and interest payments increased. This relationship is shown perfectly in Bank of America's estimated earnings from these quarters. 

Earnings bumped in early 2021, and we saw the negative relationship between rates and bank stocks take effect after the peak in October. When rates got too high, loan volume went down. You could see it in the earnings report for the second half of 2021 and the first half of 2022, where earnings decreased from their peak, and the stock price did as well. Fewer loans mean less profit, which is evidence of that second negative relationship we discussed in the real world.

Bank of America's performance through the most recent rate hikes is a great microcosm of how bank stocks perform during periods of inflation controlled by increasing interest rates. Typically, there is an initial boost in earnings and stock performance, but as fewer loans are issued, the stock price will fall because earnings do as well. 

Pros and cons of rising rates for bank stocks

In a rising interest rate environment, bank stocks present opportunities and risks for investors. 

Pros:

• Increased NIMs: Rising interest rates can lead to higher yields on loans than the interest paid on deposits, potentially widening NIMs for banks and boosting profitability.
• Improved profitability: Higher NIMs contribute to improved profitability for banks, which may enhance their overall financial performance and shareholder returns.
• Potential for share buybacks and dividends: Banks may use increased earnings to implement shareholder-friendly measures, such as share buybacks or dividend increases, providing returns to investors.
• Economic expansion: Rising interest rates are often associated with a growing economy, leading to increased demand for loans and financial services, positively impacting banks' lending activities.
• Asset quality improvement: In an expanding economy, the overall credit quality of borrowers may improve, potentially reducing the risk of non-performing loans for banks.

Cons:

• NIM compression: While rising rates can improve NIMs, a sudden or excessive increase can lead to higher funding costs, compressing margins and impacting profitability.
• Credit quality challenges: Economic slowdowns triggered by rising rates may lead to challenges in loan repayment for borrowers, potentially resulting in increased non-performing loans and credit quality concerns.
• Reduced borrowing and spending: Increased interest rates can lead to high borrowing costs for consumers and businesses, potentially dampening borrowing and spending activities, impacting banks' loan volumes.
• Market volatility: Banks with significant exposure to capital markets may face increased market volatility, impacting trading and investment banking activities.
• Regulatory changes: Changes in regulatory policies or increased compliance requirements associated with a changing interest rate environment can pose challenges for banks, affecting their operations and costs.
• Interest rate sensitivity: Banks with large portfolios of fixed-rate assets may experience losses in the value of these assets when interest rates rise, potentially impacting their balance sheets.
• Operational challenges: Implementing new monetary policies and rising rates may introduce operational challenges for banks, including adjustments to lending and risk management practices.
• Impact on mortgage market: Higher interest rates can lead to decreased demand for mortgages, affecting banks with significant exposure to the mortgage market.

Other stocks that increase with rising interest rates

When interest rates change, stock market fluctuations are widespread. Here are some other sectors that tend to perform well in a rising rate environment:

Insurance stocks 

Insurance companies invest a significant portion of their premiums in fixed-income securities such as municipal bonds. When interest rates rise, the yield on these securities increases, which can boost insurance companies' investment income and profitability.

Industrials and materials

Cyclical sectors, such as industrials and materials, may see increased demand as economic activity increases with rising interest rates.

Homebuilders and retailers

As the economy expands, consumer spending tends to increase. Homebuilders and retailers may benefit from a boost in consumer confidence and spending during rising interest rates.

Energy and commodities

Since rising interest rates may be associated with a strengthening economy, driving up commodity demand. 

Commercial real estate

While real estate investment trusts (REITs) are often sensitive to interest rate changes, certain types of commercial real estate, such as office spaces and industrial properties, may benefit from a growing economy.

Expert opinions and market outlook

In a December 13 FOMC statement, the Fed said, "the U.S. banking system is sound and resilient" but remains "highly attentive to inflation risks." 

Wall Street predicts that the Fed will not raise rates again through early 2024 due to inflation slightly dissipating and a slower job market. Fed Chair Jerome Powell said that if their economic projections are correct, "the appropriate level (of the federal funds rate) will be 4.6% at the end of 2024." 

Some economists think the rates could start lowering early in the new year. If the Fed cuts rates, it would be a load off the financial shoulders of consumers who would benefit from corresponding reduced borrowing costs, ranging from mortgages to credit card debt.

Should you buy bank stocks when interest rates rise?

Are bank stocks good during inflation? It depends. While the general safety of bank stocks can be appealing in a rising rate environment, these stocks may not be best for everyone. 

Before buying bank stocks, it's important to consider whether they are currently undervalued or overvalued relative to their earnings, book value and other relevant metrics. You can compare the current valuation of bank stocks to historical averages and other market sectors to determine whether they are a good investment opportunity.

Investing in bank stocks during a rising rate environment 

While conventional wisdom suggests that rising interest rates generally benefit banks, various factors such as economic conditions, central bank policies and market expectations play crucial roles in shaping this dynamic. 

Investors should consider the broader financial landscape and individual bank fundamentals when assessing the potential impact of interest rate fluctuations on bank stocks. As with any investment decision, thorough research and a comprehensive understanding of the market forces are essential for making informed and prudent choices. While bank stocks are known to provide more stability during times of rising inflation, it's important to remember that no individual stock is a guaranteed bet against loss. 

FAQs

Let’s review a few of investors' most common questions about bank stocks below. 

Will bank shares go up if interest rates rise? 

When interest rates rise, bank stocks can go up because banks can earn more from lending money. However, rising interest rates may also lead to decreased consumer spending, resulting in lower loan originations. Individual performance will vary by bank stock. 

What makes bank stocks go up?

Several economic factors can cause bank stocks to go up, including interest rates and economic growth. As with any stock, the financial performance of bank stocks also plays a direct role in share price. 

What happens if I put money into bank stocks in a rising interest rate environment?

While the true impact on a specific bank depends on individual circumstances, bank stocks typically increase when interest rates rise as the financial institutions have the potential to bring in more revenue.