Banks are jumping on higher rates and Citi says these three may be the best of the bunch

Published Thu, Mar 18 20211:08 PM EDTUpdated Thu, Mar 18 20214:00 PM EDT

Bond yields are surging and so are banks on Thursday. Citi said a trio of financial stocks could be the best positioned to take advantage of the higher rate environment. The 10-year Treasury yield soared to a 14-month high of 1.74% on Thursday, a continuation of the benchmarks sharp move higher since the start January. The 30-year rate also climbed 6 basis points and breached the 2.5% level for the first time since August 2019. During the climb in bond yields this year, bank stocks — which benefit from higher interest rates — have also outperformed. The KBW banking index is up 28% in 2021 on on increased optimism about the economic recovery as well as an improving rate outlook. Shares of big bank stocks pushed the Dow higher on Thursday, while the rest of the market struggled. Banks' "performance shows a strong correlation with rates, yet on stock-by-stock basis, the outperformance has been less correlated on rates and rather valuation…as investors have rotated into laggards to play for the economic recovery," Citi banking analyst Keith Horowitz told clients. "With the valuation gap between high-quality and value substantially narrowed, we expect go forward stock performance to be driven by fundamentals; with the rate outlook being a significant driver of ROTCE (Return on Average Tangible Common Shareholders' Equity) improvement from here," he added. Banks benefit from higher interest rates as their net interest margin, the difference between what banks pay on deposits and earn on loans, increases. Banks profits rise as the spread widens on the rate they borrow at in the short term and the rate they lend out at in the long term. Higher rates also allow them to charge more services and make more on their various holdings. Not to mention, increased bond market activity helps the trading side for those with that business. "With uncertainty around short-end rates moving higher, our preferred rates play is to focus on the 'bird in the hand' or those that benefit from recent move in the long end," said Horowitz. Citi said it likes buy-rated Bank of America , State Street and Bank of New York Mellon the most. The Wall Street firm said it expects positive revisions to consensus net interest margin and better-than-peer trends in the second half of 2021 and 2022 for this trio. The firm said these stocks will benefit from the deployment of cash into higher rate securities and the decline in the amount of time it takes to pay off loans. Shares of Bank of America rose 2.6% on Thursday. State Street and Bank of New York Mellon gained 0.5% and 0.5%, respectively. Citi see's these three stocks rallying over the next year. The firm has a $37 per share price target on Bank of America, which is below its current share price, and a $92 per share target on State Street. Citi expected Bank of New York Mellon to reach $55 per share in the next 12-months. — with reporting from CNBC's Michael Bloom.

Brian Moynihan, CEO, Bank of America

Scott Mlyn | CNBC

Bond yields are surging and so are banks on Thursday. Citi said a trio of financial stocks could be the best positioned to take advantage of the higher rate environment.