As Bank Earnings Arrive, Investors Seek Clarity

Big banks kick off fourth-quarter earnings season this week in a very different place than just a quarter ago. 

Back in October when banks last reported, interest rates were in freefall after a 50-basis point September rate cut by the Federal Reserve. Now, after two more 25-basis point cuts, the Fed appears on pause amid sticky inflation, sapping some enthusiasm about potential business and consumer demand for banking services, but potentially aiding future profits in one key area. Treasury yields have risen 90 basis points from their September lows and are approaching their 2024 peaks.

Climbing rates are a mixed bag for banks. Every sector is sensitive to rate policy, but big banks have extremely high exposure. Lower rates can light a spark for banks handling everything from mortgage loans to initial public offerings (IPOs). They also mean banks pay less interest on money stashed in their vaults. At the same time, higher yields crimp demand for banking services but also can boost their net interest income (NII), which measures the money banks make on lending minus what they pay to customers.

The yield curve has steepened in the last few months, meaning long-term yields in the Treasury market have built a higher premium to shorter-term yields. The recent Fed cuts have had an impact on short-term rates, but the back-end rates, including everything from the 10-year to 30-year yield, have firmed. The trade-off for the banks will be between a slowdown in mortgage applications and refinancings versus the money they make from NII. 

This means for individual banks, it's important to note the breakdown of revenue streams. Those with more exposure to retail and corporate lending could be more negatively affected by a continued rate path of higher for longer. That's potentially bad news for regional banks with heavy exposure to commercial loan markets. Those helped most by NII over the last few years as rates rose, including the major Wall Street firms, could get a fresh tailwind from the steepening yield curve and resulting NII gains.

Falling rates last year helped financial stocks, including banks, lead all S&P 500 sectors in earnings growth at 39.7%, according to research firm FactSet. That was well above overall earnings growth of 9.4%. However, things could change dramatically in 2025. Financial stocks are seen growing earnings per share just 9%, below the 14.8% FactSet estimate for the S&P 500.

Part of that has to do with tougher comparisons – it's harder to grow earnings when a sector is coming off nearly 40% annual earnings growth. But analysts could be baking in the impact of rates staying higher for longer. The Fed's current 4.25%-4.5% target range is expected to fall to around 4% by the end of 2025, according to the CME FedWatch tool, well above projections a few months ago for 3.5% or below. Higher rates can put a brake on banking profits.

Profits aren't the only possible roadblock. Even as financial sector earnings grew sharply last year, the sector grew revenue just 5.7%, a figure that analysts expect to fall to 4.9% this year. Higher rates often mean small businesses and consumers take out fewer loans and larger companies conduct less merger and acquisition (M&A) activity, all of which could suppress banking revenue.

Big banks were a major contributor to the nearly 40% financial sector earnings growth in 2024, but part of that reflected easy comparisons versus a year earlier when big banks saw significant charges related to Federal Deposit Insurance Corporation (FDIC) special assessments and other items that hurt their EPS in 2023. This year they won't have the benefit of such easy comparisons.

It's not all a sad story as banking giants like JPMorgan Chase (JPM), Citigroup (C), Wells Fargo (WFC) and others prepare to report in coming days. Yes, rates might stay relatively high versus the zero level that large financial institutions and their clients got used to between 2008 and 2021. But one reason rates are stubbornly high is the strong U.S. economy, where the Atlanta Fed's GDPNow meter recently pegged fourth-quarter gross domestic product (GDP) growth above 3%.

This follows better than 3% third-quarter GDP growth, and a strong economy traditionally keeps the banking business healthy. Though analysts expect GDP to flag in coming months, there's also hope that more business-friendly tax and regulatory policy under the new U.S. administration could support growth. A strong economy and a lighter regulatory burden that might ease M&A activity generally helps banks, which may see more lending and other activity even if rates remain at 4%, so long as that accompanies a growing economy.

It's less clear how some of the new administration's proposed tariff and immigration policies might affect the economy, however. Worries about the possible inflationary impact of those policies hurt the stock market and sent Treasury yields up in December, especially after the Fed made clear that rate cuts are likely on pause until inflation cools. Still, it's uncertain which policies might take effect or when they might go into place once Republicans take the reins in Washington, D.C. 

One thing that might spark worries is the timing of policy changes. It's relatively easy for a president to toughen tariff policy with the stroke of a pen, as Trump often did in his first term and as President Biden continued to the last four years. Reducing corporate taxes, though, requires Congress, and December's budget battle shows that Trump can't necessarily count on his own party to support every fiscal move. Tariffs are easier to change and less helpful to banks than lower taxes, which take longer to push through.

Uncertainty around government policy likely had an impact on bank stocks after the election. Initially, banks posted meteoric gains, with the Nasdaq Bank Index (BANK) up 16% in just two weeks by November 25. Then worries set in about possible inflation associated with tariff and immigration policy, and the BANK index began to wilt. The Fed's cautious outlook delivered a hammer blow, sending the index below where it was before the election. That capped a volatile year for financial stocks, which delivered roughly 18% growth between January 1 and Christmas, trailing the 25% gains over that period by the S&P 500 index (SPX).

Besides the rate outlook, here are three things to watch as big banks report, starting with JPMorgan Chase, Wells Fargo, and Citigroup on Wednesday. They're expected to be followed by Bank of America (BAC), Morgan Stanley (MS), and Goldman Sachs (GS) on Thursday.

Back in mid-September, JPMorgan Chase shares plunged after the bank told investors not to put much trust in analysts' estimates for $90 billion in net-interest income in 2025. That's when it became clear that falling rates could threaten banks' NII. Rates for the 10-year Treasury note yield bottomed near 3.6% right around the Fed's September meeting, and at the time appeared to signal pending economic weakness, a potential negative for banks' business models beyond NII.

The situation now isn't 100% different, but it's certainly more favorable from an NII perspective with the 10-year yield touching 4.6% by late December and futures trading building in just two rate cuts in 2025 rather than four. Bank executives are likely to address the NII outlook on their earnings calls and investors might want to monitor for any change in tone.

With the major banks all sharing earnings just days before the Trump administration takes office, bank leaders might address possible policy changes. Taxes and regulations arguably carry the most weight.

While every industry would likely enjoy improved profits if taxes fall, lower taxes arguably help banks even more because they free funds from business clients for new ventures. A company that expects better profits could be more willing to borrow money to invest in new plants and equipment, for instance. And if personal taxes fall, that could lead to increased purchases of homes and cars, again helping banks.

On the other hand, proposed tariffs and deportations could cause inflation that sends rates higher, hurting the economy and potentially diminishing opportunities for the banks. 

An easier regulatory climate in Washington could give investment banks more business on the mergers and acquisitions (M&A) front, too. Under the Biden administration, several high-profile M&A deals ran into trouble, notably the attempt by Kroger (KR) to buy Albertsons (ACI) and the proposed merger of Spirit Airlines and Frontier Airlines (ULCC). The Biden administration also opposed the attempt by Nippon Steel to buy U.S. Steel (X). 

"We are seeing increased client demand for committed acquisition financing, which we expect to continue on the back of increasing M&A activity," said Denis Coleman, chief financial officer at Goldman Sachs, on the company's October earnings call.

For the biggest banks, extending loans is arguably a secondary aspect of business. Investment banking and market activity might have even more impact. Bank of America was an example last time out when investment banking and trading revenue surged even as NII fell. Though the fourth quarter wasn't notable in terms of M&A or IPOs, market performance for banks with major trading businesses could again stand out.

Stocks drove to record highs during the fourth quarter and bonds swung up and down quickly throughout late 2024, with volatility possibly meaning more fees for banks' trading divisions. 

As always, when the big banks report, watch each institution's general level of loan activity and the quality of their existing loans. Banks still have a good deal of outstanding loans on their books due for refinancing this year. Falling rates over the last few months could make it easier for customers and businesses to refinance loans. 

Though big banks get much of the attention, smaller regional banks begin reporting next week and might provide investors more insight into the small businesses and consumers that form much of their customer base. They can often provide ground-level views of emerging trends like home buying and business loans demand.

For the major banks reporting Wednesday, analysts expect the following:

• JPM: EPS of $4.09, +34% from a year earlier
• WFC: EPS of $1.35, up 4.3% from a year earlier
• C: EPS of $1.22, up 45.2% from a year ago