Increasing long-term interest rates are causing investors fear in the marketplace and giving them less confidence in which stocks to buy lately.
But rising interest rates may actually benefit the banking sector, and investors, in turn, can benefit if they identify the best bank stocks to buy.
Today's interest rate climate seems to be in a period of rapid transition.
We learned from the FOMC meeting minutes released today (Wednesday) that about half of the committee's members think the $85 billion a month bond-buying program should end this year. The yields on long-term bonds have already slid quickly in recent weeks on fears the Fed would scale back its quantitative easing program.
In just one month, 10-year U.S. Treasury bonds' yield rose to 2.6% from 2.0% and 20-year bonds' yield rose to 3.6% from 3.17%.
After low interest rates drove stock prices higher the past few years, giving investors ample choice in good stocks to buy, recent weakness in the bond market has intimidated investors into spurts of heavy selling. Traders are worried that the bond market has hit the low in yields for the year and, in tandem, that the stock market has hit its price highs.
In the months ahead, investors must be more diligent in ferreting out which stocks to buy based on which stocks will benefit from likely interest rate hikes. After all, rising rates will indeed be a short-term negative for the general stock market.
But investors who are intent on finding the ideal stocks to buy will find the rising rates offer long-term gains for the financial services industry.
Banks make a significant portion of their income on the interest rates on loans they issue such as mortgages, commercial loans and credit cards. Those loan rates are based on longer term rates like the 10- and 20-year Treasury bond yield. The higher the interest rate on their loans, the more banks earn.
Financial institutions have suffered with the recent low long-term rates, but banks now should be among the ideal stocks to buy as interest rates rise.
In other good news for banks, the deposits rates that they pay out are usually set by short-term rates, which the Fed has indicated that it's unlikely to raise any time soon. So, with longer-term rates rising as the short-term rates remain low, banks are well positioned to reap stronger profits.
But even among banks, investors have to be savvy about which stocks to buy. The larger institutions may seem like they're in the best position to reap more profits amid higher rates, but they really derive a larger percentage of their income from trading, not necessarily from loans.