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Why the Lloyds share price fell 4.5% yesterday

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Yesterday was always going to be a big day. The Bank of England meeting was being watched carefully by many investors. The overwhelming thought was that the committee would raise interest rates by 0.15% and signal more hikes to come next year. For investors holding shares in Lloyds Banking Group (LSE:LLOY), this meeting had the potential to cause a large rise or fall in the share price. Unfortunately, it was a drop of 4.5%. Here’s what happened.

Understanding the build-up

Let’s rewind things by a few months. Back in early summer, it didn’t really look like the Bank of England would be raising interest rates any time soon. However, rising inflation changed this. It shot up above 2% in May, with the latest reading for October being 3.1%. To put this into perspective, the target rate for the bank is 2%. 

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One way to control inflation is to raise interest rates. This should help to nudge some economic activity from spending to saving. Given that inflation has been rising since May, investors shifted expectations that the bank would raise rates sooner rather than later.

Lloyds shares actually benefited from this, and popped 10% higher over the past three months. Over a one-year period, the return is 72%. The reason why the share price moved up was because higher rates are a good thing for Lloyds. 

The main reason for this is to do with the net interest margin, a key source of revenue for the bank. This margin is the difference between the rate it lends at versus the rate it pays on deposits. Higher base rates allow Lloyds to increase the margin it makes. 

Reviewing expectations for Lloyds shares

Now let’s fast forward to today. Personally, I think Lloyds shares already had an interest rate priced in. In other words, the good news of a hike was already expected by the market. It was a surprise, but the Bank of England decided against raising rates today. It might raise them in December, or it might not happen until 2022. 

Either way, it was a disappointment. This was shown by Lloyds shares falling as investors adjusted their expectations. And it was the case not just with Lloyds, but with other banks including NatWest and Barclays. In fact, this trio made up three of the four worst performers in the FTSE 100 on Thursday.

Looking forward, I think that interest rate projections will continue to cause volatility for Lloyds shares. However, with the pushback today, I think the risk/reward is in favour of the share price moving higher. I don’t think the Bank of England will risk disappointing markets again, and will have learnt its lesson in being clear about what’s going on.

On that basis, I’d argue Lloyds shares are a buy for me right now. The main risk to this view is that the UK economy could struggle in the winter, causing the central bank to abandon hiking rates.

Overall, I’d allocate a small amount of money to buying Lloyds shares after today.

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jonthansmith1 has no position in any share mentioned. The Motley Fool UK has recommended Barclays and Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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