In a recent speech*, Peter Praet, the chief economist of the ECB, stated that “the longer the current low-interest rate environment persists, the greater the challenges for bank profitability will be” adding that “the underperformance of bank equities may actually be testament to such concerns”.
The upper half of the chart shows that the relative performance of bank stocks in the Eurozone versus the overall index is indeed very closely correlated with the evolution of government bond yields (represented here by 10 year Bund yields). It seems investors very much look at banking as a maturity transformation business whereby higher long-term yields with unchanged short term rates would imply an improved profit outlook. Admittedly, bank profitability depends on many factors but the steepness of the yield curve is a key one and the market is anticipating the positive impact of new business at higher rates on future profits. The lower half of the chart shows that the relative performance of banks versus the overall index is positively correlated with the behaviour of the latter: when the index rises, banks tend to outperform and vice versa. Combining the upper and the lower part, this implies that Eurozone equities have been positively correlated with bond yields. In the course of this year, a more upbeat outlook for the economy, as reflected in higher bond yields, has been welcomed by the stock market and even more so by banking stocks.
*Monetary policy and the euro area banking system, Speech by Peter Praet, Member of the Executive Board of the ECB, at VII Financial Forum organised by Expansión and KPMG, Madrid, 4 October 2016
by William DE VIJLDER