Good news for Canadian banks

RBC touches all-time highs as falling rates drive performance

The direction of short-term interest rates is now definitely downwards. The Bank of Canada cut rates by 25 basis points three times over the summer and topped that off with a half percentage point cut in October. In five months, the target rate has fallen to 3.75% from 5%.

South of the border, the U.S. Federal Reserve cut its fed funds rate by a larger-than-anticipated 50 basis points, to 4.75%, in September. In Europe, the European Central Bank (ECB) has cut rates three times by 25 basis points to 3.25%. The Bank of England and Bank of Switzerland have also begun cutting rates.

This has resulted in the yield curve (the difference between short-term interest rates and the benchmark 10-year bond yield) reverting to positive in Canada and the U.S. for the first time in over two years.

The shape of the yield curve is regarded by many observers as the best predictor of economic growth. An inverted curve, where short-term rates are higher than long term, has had an excellent track record of predicting recessions. The move to a positively-sloped curve is an encouraging development for the economic outlook.

Lower short-term rates mean that borrowers refinancing mortgages should not face as big a jump in payments as has occurred over the last two years. Refinanced mortgages account for approximately 20% of the Canadian market each year, given that the vast majority of mortgages have five-year terms.

Good news for Canadian banks

This is obviously good news for Canadian banks, where domestic mortgages make up around 30%-35% of their loan books. The increase in provisions for credit losses (PCLs) have risen sharply over the last couple of years. For the quarter ending Jan. 31 this year, PCLs rose from $690 million to $1 billion for TD, from $638 million to $967 million for Scotiabank, and from $538 million to $813 million for RBC.

Looking just at Royal Bank of Canada, PCLs for the nine months to July 31 rose $644 million to $2.39 billion. This reflected higher PCLs for personal and commercial banking partially offset by lower PCLs in wealth management and investment banking.

The reduction in PCL increases has been supported by strength in wealth management, as stock markets in Canada and the US have risen by 29% and 38% respectively for the S&P/TSX 60 and S&P 500 indices. Plus, the bond market has recovered strongly. The strong markets have led to a recovery in dealmaking and IPOs, helping the banks' investment operations. As a result, the iShares S&P/TSX Financials ETF is up 41% over the last twelve months and the KBW Bank ETF in the US is ahead a remarkable 61%.

Interest rates are set to fall further in the U.S. by year-end. ECB Chair Christine Lagarde is forecasting another three reductions in the euro area next year, as Europe flirts with recession. The outlook for the banks’ interest income and reduced PCLs should mean earnings will continue to show decent growth.

As for investment choices, Royal Bank of Canada (TSX: RY) has benefited from steepening yield curves and strong asset markets. RBC is the largest bank in Canada and one of the ten largest in North America. Its market share increased by 2% to 23% after its $13.5 billion takeover of HSBC’s Canadian operations earlier this year. It has particular strengths in retail, investment banking, and asset management and has the largest share of mortgages and corporate lending in Canada.

After hitting a low of $108 over a year ago, RBC’s share price is up 45% over the last 12 months, touching an all-time high of $175 in mid-October. The bank reported net income of $4.5 billion ($3.09 per share) for the quarter ending July 31. That was up $626 million (16%), of which HSBC Canada contributed $239 million.

RBC continues to benefit from its strong position in Canadian retail and commercial banking, helped by the acquisition of HSBC’s Canadian operations and the improved performance of its U.S. City National subsidiary after a $3 billion injection last year. It’s a suitable holding for both income and growth equity portfolios. As always, consult with your financial advisor before investing to ensure the stock aligns with your risk-tolerance and financial objectives.

Gavin Graham is a veteran financial analyst, money manager, formerly Chief Investment Officer of BMO Financial, and a specialist in international investing, with over 35 years’ experience in global investment management.

Notes and Disclaimer

Content © 2024 by Gavin Graham. This article first appeared in The Internet Wealth Builder newsletter. Used with permission.

The commentaries contained herein are provided as a general source of information, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.

The views expressed in this post are those of the author. Equity investments are subject to risk, including risk of loss. No guarantee of performance is made or implied. The foregoing is for general information purposes only. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.

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