Canada’s central bank just announced a surprising one percentage point increase in interest rates. It is clear that the country is worried about the rapid rise in inflation, but the remedy could plunge Canada into a recession.
The same basic story is true for the United States. And yet, there is both good and bad news for banks like Bank of Montreal (BMO 0.67%), Toronto-Dominion Bank (TD 0.20%)and Royal Bank of Canada (RY 0.29%).
The bad news
The obvious concern today is that inflation is too high. This eats away at the purchasing power of money and makes people more and more unhappy as their money buys less and less over time. The solution is to get inflation under control, which usually means that central banks raise interest rates. This is exactly what the American central bank is doing, as is the central bank of Canada. Recently, both have opted for bigger rate hikes, with Canada’s 1% rise suggesting its central bank is very concerned about prices spiraling out of control.
A little inflation is good, but too much can lead to material economic problems. The fact is that rising interest rates can lead to economic contraction if central banks are not careful. Recessions, when they occur, are not good for banks. The decline in economic activity leads to a drop in demand for the products and services offered by banks. And economic downturns usually lead to an increase in the amount of bad debt that banks have to deal with.
Canadian banks are well positioned on both fronts. First, the Canadian banking industry is heavily regulated, so a few big players have entrenched positions. Thus, even in the event of a slowdown, it is unlikely that the Canadian banking giants Bank of Montreal, Toronto-Dominion and Royal Bank of Canada will see their positions in the industry significantly weakened.
Additionally, Canadian regulators tend to take a conservative approach, resulting in these banks having very robust Tier 1 capital ratios. This ratio is a measure of a bank’s ability to handle adversity, with higher numbers being better than lower numbers. Bank of Montreal’s Tier 1 ratio was 16% at the end of the second quarter of the year, TD Bank was at 14.7% and Royal Bank of Canada was at 13.2%. By comparing, CitigroupThe Tier 1 ratio at the end of the last quarter was 11.9%.
Based on this important industry metric, it appears these Canadian banks are extremely well positioned to weather a downturn, just as they did during the Great Recession, when each maintained their dividend levels even as its American counterparts were reducing their payments.
The good news
The increase in central bank interest rates is not bad news for banks, however. Essentially, banks can only charge a limited amount for the loans they make, and rates are indirectly dictated by central bank rates. Over the past few years, rates have been historically low, so banks have not been able to charge much for their lending services. This means lower earnings.
With rising rates, however, banks are able to increase the amount they charge for loans. And if they increase the amount they pay on things like bank accounts at a slower rate, they can quickly increase the amount of money they earn. In other words, higher rates should improve the longer-term earnings outlook for banks. There may be short-term issues to deal with in a recession, but for financially conservative banks, like the Bank of Montreal, Toronto-Dominion and Royal Bank of Canada, this should be relatively easy to deal with.
But investors tend to think about the next quarter, not the next decade. Bank stocks therefore sold off, pushing dividend yields higher. If you can think long term, this is an opportunity. The return of the Bank of Montreal is 4.7%, that of Toronto-Dominion is 4.5% and that of the Royal Bank of Canada is nearly 4.4%. You’ll have to pay foreign taxes on those dividends (which can be reclaimed on April 15), and exchange rates will change the quarterly total U.S. investors will actually receive. However, if you’re looking for reliable dividends in the financial sector during a tumultuous time, this trio might be just what you’re looking for.
hold your nose
A recession will eventually occur, even if central bank rate hikes don’t lead to one right away. So there will be a bad period for banks to go through at some point, probably sooner rather than later. And it will be a problem for the Bank of Montreal, Toronto-Dominion and the Royal Bank of Canada. However, history suggests they will take the hit in stride, a fact supported by their currently strong Tier 1 capital ratios. The risk/reward balance here seems to be tilted in favor of the reward today.