Enjoy the interest rate cut party while it lasts, Fools! ASX bank investors are mortgage holders are popping the Champaign after the Reserve Bank of Australia (RBA) cut interest rates to new record lows yesterday.
The S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index jumped 0.5% during lunch time trade with financial stocks outperforming the broader market.
The Commonwealth Bank of Australia (ASX: CBA) share price, Westpac Banking Corp (ASX: WBC) share price, Australia and New Zealand Banking Group (ASX: ANZ) share price and National Australia Bank Ltd. (ASX: NAB) share price are up around 1% to 1.5% each at the time of writing.
There's an expectation that lower rates will lift demand for mortgages with mortgagees winning from lower repayments and bank investors benefiting from the growth in bank revenue.
Bank profits could fall by 10%
But there could be a flaw in this thinking. One of my contacts in mortgage broking strongly believes the big banks won't be passing on the next rate cut, and the only reason why the big four passed on all or most of the 25-basis point reduction in the cash rate to consumers was due to political and public pressure.
He isn't the only one thinking that. The analysts at Macquarie Group Ltd (ASX: MQG) calculated that a quarter percentage point cut in the term structure of interest rates lowers the big four's profitability by circa 2% to 3% and the regional banks by around 4% to 7%.
"With every incremental interest rate cut, the impact on banks' profitability accelerates," said Macquarie.
"However, the next forecasted 25bps rate cut would have a cumulative impact on earnings of ~5-7% for the majors and over 10% for the regionals."
The bank most at risk of a profit squeeze is Bendigo and Adelaide Bank Ltd (ASX: BEN), according to Macquarie.
Don't count on banks passing on the next rate cut
What this means is that the banks will be much more reluctant to pass on the next rate cut (assuming the RBA goes again) given that their earnings are already under pressure.
It's also worth nothing that bank stocks tend to underperform in a falling interest rate environment, although the silver lining is that their current share prices may not fall that much despite the rate headwind.
"While banks' outlook is adversely impacted by falling rates, the rationale for rate cuts is arguably reflective of challenges for the broader economy which is also reflective of the broader market (trading at ~20x PE multiple)," explained Macquarie.
"In this context, the ~30% discount that banks are currently trading at may already be reflective of earnings pressures, and relative downside for the sector may already be captured in share prices."
Ultimately though, the performance of bank stocks will come down to how long this interest rate cutting cycle will last. The longer it drags on, the tougher it will be on bank profits while mortgagees will probably not enjoy the full benefits of the falling official cash rate.
