Expectations of higher interest rates could be good for stocks in the coming months, though not for banking shares, according to a new analysis.
While the Federal Reserve isn't expected to raise rates for months, investors are beginning to brace for what will happen once the central bank starts tightening monetary policy as the economy improves.
One scenario, laid out Tuesday in an extensive analysis from Keefe, Bruyette & Woods, is that stock prices historically rise in anticipation of the initial rate increases, while financials underperform.
Once the rate increases begin, financials continue to slump but then recover in the six months after the final increase, KBW said.
With such a trend in place the firm said investors will need to choose wisely when picking investments in financials.
"We think you need to be pretty selective about banks amid rising rates," KBW analyst Fred Cannon said in an interview. "The future is always a little different than the past and this time that certainly will be the case."
Investors in the broad market have been looking forward to a rate increase as a signal that the economy is starting to recover. They got their first taste of the Fed repositioning itself for changing conditions when the central bank last Thursday announced it was hiking the discount rate it charges banks for emergency borrowing.
Stocks had a muted reaction to the move as Fed officials reassured the markets that it was not ready to back off its accommodative monetary policy until conditions improve more. Most analysts say the Fed funds rate is likely to stay extremely low until unemployment gets below 9 percent and the housing market shows stronger signs of improvement.
In this climate, KBW says investors should avoid banks that have mostly fixed-rate loans and a higher rate on deposits.
For example, banks that did not lower their lending rates to correspond with the sharp cut in the Fed funds rate conversely will not benefit once the rate starts rising. The funds rate's biggest impact is on its tie to consumer borrowing rates.
"The banks probably won't benefit during the early part of the raising-rate cycle because in many cases they have floors on the loans and in some cases didn't lower the prime rate in line with the Fed funds rate," Cannon said. "As we see initial increases in interest rates, the banks may not be able to pass that along to very many customers."
Despite some of the difficulties facing the industry, KBW has identified a basket of banks it thinks can move higher because of their variable rate loans and low deposit rates.
KBW picks are: TD Ameritrade, Bank of New York Mellon, Cullen/Frost Bankers, Comerica, CME Group, Discover Financial Services, Federated Investors, Fulton Financial, Intercontinental Exchange, MF Global, M&T Bank, Northern Trust, OptionsXPress, Private Bancorp, Charles Schwab, Stifel Financial, SVB Financial and Tradestation.
"In our basket of stocks we attempt to take into account the nature of the next rate increase resulting from the Fed's unique accommodative policy during the financial crisis," the firm said in its analysis. "In particular, interest rates have been lower, longer, with a more aggressive approach (quantitative easing) than in any post World War II cycle."
Indeed, Cannon said three principal factors feed into the notion that this recovery will be different than many of its predecessors and thus present greater challenges for investors: Exceptionally low rates, the Fed's expected move to pay interest on excess reserves; and the temptation for banks to invest in fixed-income securities during the time of low rates that could turn disadvantageous later when rates rise.
Cannon said investors who want to play banks as a broad group, particularly through exchange-traded funds, will find rising rates a barrier.
Of course, that could not be a big worry until much later in the year.
"The reason they'd be raising rates is they see a fairly strong economy and have future concerns about inflation," Cannon said. "We're a long ways away from that."