Why regional banks are set to benefit from easing interest rates

Christopher McGratty, head of US bank research at KBW, a Stifel Company, joins Market Domination to discuss how the Federal Reserve's rate easing cycle will impact regional banks and lays out some of his top picks in the sector.

"We're figuring this out as we go. The 50-basis-point cut last week was, as Powell said, a good, strong start," McGratty tells Yahoo Finance. He explains that to get to a terminal rate of 3%, the Federal Reserve will likely initiate 25-basis-point cuts for the rest of 2024 and throughout 2025.

He believes that easing rates will be bullish for regional banks, explaining, "Over the last 18 months, the largest banks have significantly outperformed the regional, the smaller, banks to the point of 2,000 basis points. And so the reason for that is their balance sheets and their income statements are less reliant on interest rates than the small banks. So what you've seen over the last month or two is a little bit of a catch-up trade. The smaller banks have performed better. You've seen the yield curve disinvert."

McGratty highlights that mergers and acquisitions (M&A) are another trend in the banking sector, noting that 3%-4% of banks are lost to consolidation every year. "What we've seen over the past six months is we're starting to see M&A resume off a very low trough. So the comparisons are getting better," he says. As interest rates continue to fall, he expects M&A activity to pick up. However, he notes that won't likely be the case for larger banks as they deal with regulatory roadblocks.

He points to Comerica (CMA) as one of his top picks, explaining that the bank is poised to benefit from easing interest rates: "They were very early and aggressive hedging rates as they were going up. So effectively, they've converted a highly variable rate loan portfolio to a 50/50 mix per se. So margins should actually begin to expand over the next two years."

McGratty is also bullish on Western Alliance (WAL), believing that the bank's internal efforts to build capital have succeeded. He adds that its mortgage business will also get a boost from lowering rates. Western Alliance is trading at about nine times its earnings, and McGratty believes that its earnings ahead will be above average.

For more expert insight and the latest market action, click here to watch this full episode of Market Domination.

This post was written by Melanie Riehl

Video Transcript

After a period of rate hikes that pressured the banking sector, particularly regional banks.

Last week's Jumbo rate cut by the fed could turn headwinds and tail winds for the sector just a few minutes till the closing bell on Wall Street.

We're looking at how to navigate regional bank stocks with the Yahoo finance playbook.

And joining us now is Christopher mcgrady, head of us Bank Research at KB WS Steel Company, Chris.

It is good to see you.

So uh maybe you kind of start with a high level question, Chris I'm wondering, you know, do I have to as investor believe that Jay Powell as kind of a, as rare and tricky a as it may be?

I have to believe he has stuck the soft landing Chris before I commit capital to your, to your coverage universe, the regionals.

Well, thanks for having me back, Josh.

I we don't know, I mean, Josh, it full dis full transparency, you know, we're figuring this out as we go.

Um the 50 basis point uh cut last week was, was as, as Powell said, a good strong start.

And so, you know, we are, if you look at expectations for rates, terminal rates are going to 3% or at 5%.

We're going to three.

I think the 50 was the initial move we're gonna see probably 20 fives uh throughout the, the back half of this year or next year.

And ultimately lower rates should take some of the stress off the system that we've had.

I I get that, but I am curious about your, your call that the fed pivot is bullish for regionals kind of overall.

Uh Are there any idiosyncratic challenges that investors should keep an eye out when they're sussing out individual names in the space?

Yeah, I guess to answer that.

Let me step back and, and what's happened over the past 18 months?

So over the last 18 months, uh the largest banks have significantly outperformed the regional, the smaller banks to the point of, you know, 2000 basis points, right?

And so the reason for that is their balance sheets and their income statements are less reliant on interest rates than the small banks.

So what you've seen over the last, you know, month, month or two is a little bit of a catch up trade.

The smaller banks have, have performed better.

You've seen the yield curve dis invert.

We've had the 60 we've had the longest yield curve inversion in 62 years, just end with the twos 10.

So there is a bit of a catch up trade with, with the small banks to the to the, to the large camp, we are market weight, the banks just to be clear, we are market weight, we are finding spots uh individually uh as opposed to the broader group.

Can I ask you, Chris just about another trend.

I'm just curious whether you think consolidation is gonna be a trend, a theme in your space, you know, not near term but let, let's just say near to intermediate term that we should watch as investors.

Just because Chris, you know, there are correct me, if I'm wrong, there are thousands of regional and community banks across the country.

So I'm curious whether you think that's gonna be a theme and whether you think regulators would permit it, we're seeing it.

Uh There's 4000 banks in the country.

On average, you lose about 3 to 4% of the banks uh to consolidation every year.

Now, what we've seen over the past six months is we're, we're starting to see uh m and a resume off a very low trough.

So the comparisons are getting better.

We're still not seeing Josh, the largest bank deals, the ones that would be, you know, kind of on the front of the newspaper.

Um And because of that is, that's largely because of regulation.

We don't know what the rules are.

Uh We did have positive news with basel three, some of the rules are relaxed, but we still haven't seen a large bank transaction go off in some time, we think the pieces will, um, will align.

Now, the political, the election is a big one but overall interest rate marks that are one of the reasons why we haven't seen, uh, deals go off for the past year and a half.

Those are narrowing as rates come down.

So we think as the economy, um, you know, firms up as, as rates come down, you should see more activity.

All right.

Well, let's talk about some of your individual picks and I'm going to go to America first because you somehow manage to get a brave heart reference into a regional banks note, which I I got to say, I love it.

Talk to me about why you have an out perform on this name banks.

Uh You know, coma historically is, is a stock to buy when rates are going up.

90% of the loan portfolio is variable, which means their margins expand significantly as rates go up.

Uh what's different and why we like to call is a little bit of a controversial call.

Today is their balance sheet is actually flipped.

Uh They are poised to benefit when rates go down.

And the reason for that is they were very early and aggressive hedging rates that they were going up so effectively, they've converted a highly variable rate loan portfolio to a 5050 mix per se.

So margins should actually begin to expand over the next two years and to your point.

We upgraded the stock about three weeks ago.

Really we waited for rate clarity but when rate clarity happened, we saw two catalysts get locked.

Number one is earnings improvement.

This is a company that's gonna grow earnings nearly 50% over the next two years.

And number two, because rates are going down, there's a capital narrative capital return narrative as the book value tangible book grows 60 70%.

The last piece of the call is, is buybacks.

Uh This is a company a year and a year and a half ago, people were talking about, did they have enough capital?

Uh When they talked recently at a at a competitor conference, they talked about buybacks being part of the narrative as soon as uh the fourth quarter, Chris, another name I want, I wanna get your take on Western Alliance, which has had a nice move already.

Chris, it's up about 32%.

This year.

You have an out perform on it.

What, what moves it higher, Chris.

Yeah, this has been a uh a really high beta stock up and down over the last 18 months.

You know, it was caught up uh guilt by association last year with, with the bank uh bank crisis.

Uh what they did successfully is they internally focused, they built capital, they built liquidity and uh and now they're back on their front foot, they didn't have to issue stock.

And so the companies uh really kept the earnings power intact from here.

Um, a couple of reasons why we like it in a downright scenario.

Number one, they have a mortgage business that should start throwing off more revenues as rates come down.

Number two, as rates come down, people are gonna be less concerned about credit quality and this is a higher risk uh proposition within the regional banks.

And number three, this is a stock that trades at nine times earnings and we, we think they'll have above average earnings and tangible value growth.

Chris, thank you so much for your time and those stock picks.

That was great.

Thank you, sir.

Thank you.