Many prominent investors and economists have stated that Donald Trump’s election means a possible end to the era of low interest rates that have been a massive tailwind for bank stocks during the past several years. Net interest margins for Canadian banks have been on a fairly steady downward trajectory since 2003.
Considering many of Trump’s policies are extremely pro-growth (massive tax cuts, de-regulation, infrastructure spending) analysts at Goldman Sachs see three rate hikes by the Federal Reserve in 2017 with their short-term Fed Funds rate hitting 1.5% by the end of the year (a full percentage point above where it is today).
For Toronto-Dominion Bank (TSX:TD)(NYSE:TD), this is perhaps more important than for any other Canadian bank. TD has the highest interest rate sensitivity of any Canadian bank. This means that as rates rise, TD can be expected to see a larger profit boost than it peers, but it also means that when rates fall (as they have been), TD will suffer.
It is important to remember that banks earn a portion of their revenues by effectively borrowing money from consumers via deposits, paying a low (or no) interest rate on these deposits, and then lending and investing these funds long term in mortgages, bonds, and other products. As rates rise, a bank can lend at higher rates and earn a greater margin.
As U.S. rates rise (and as Canadian rates presumably follow), TD is set to benefit in two ways. Firstly, TD has large U.S. exposure (34% of 2016 operating earnings). Secondly, TD is a deposit-rich bank, especially in the U.S. TD has $234 billion in deposits in its American operations compared to only $141 billion in loans, and the excess is largely invested in a bond portfolio. As interest rates in the U.S. rise, TD will earn more interest from its bonds, while the interest on its deposits will only rise marginally, meaning a big boost in revenues.
How much would extra would TD earn from a 1% boost in interest rates?
A one percentage point boost in interest rates across the board would have a massive effect on TD’s earnings and would certainly be a tailwind, especially for TD’s U.S. operations.
While TD declined to provide interest rate sensitivity during its last earnings conference call, TD did provide information back in 2013, and it is possible to use this information to provide a back-of-the-envelope calculation to give an idea of how much TD would benefit from a one percentage point hike in rates.
TD has approximately $325 billion in non-maturity deposits. About 60% of these deposits are non-rate sensitive. These are things like cheuquing and savings accounts, and the bank does not have to pass on much of the benefit of rising rates to these depositors. The remaining 40% of the deposits are rate sensitive, and the bank would have to pass on approximately half of any gain from rising rates to these depositors.
What does this mean? It means that on 40% of the deposits ($130 billion), the bank would have to pass on half of a one percentage point increase to consumers ($650 million), but it would realize $650 million in extra profit immediately.
The remaining 60% of deposits ($195 billion) are not rate sensitive, so the bank would not have to pass anything on, which means the bank would realize an extra $1.9 billion from a one percentage point boost in rates. Combined, this is a massive $2.5 billion in extra profits from an increase in rates.
If rates only increase in the U.S., this would be about $1 billion, or a sizable 11% of 2016’s operating income. It is important to note that not all of this increase would come immediately in 2017 (since many of the bonds and fixed rate mortgages that TD invests in need to mature and re-price at the higher rate).
Nonetheless, in a scenario where rates increase in both Canada and the United States, the potential impact for TD could be sizable and could help serve as a cushion against some of the headwinds being faced by banks (like a weakening housing market).
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Fool contributor Adam Mancini has no position in any stocks mentioned.