At the time of writing, Lloyds (LSE:LLOY) shares are down 3% over the past year. That’s clearly not a great return for shareholders.
And to some extent, that reflects the health of the UK economy. Consumer banks, namely those lending money to individuals, through loans, mortgages and credit cards, generally tend to be classified as cyclical stocks.
This is because the demand for their services grows during periods of increased economic activity and dips when activity wanes. During recessions, loans can turn into bad debt, and impairment charges soar.
So, as the UK enters a recession, it seems unusual to be talking about a multi-billion pound tailwind.
What is this tailwind?
Interest rates had been at near-zero levels for over a decade. This means net interest margins (NIMs) — the difference between lending and savings rates — have been low.
But the interest rate environment has changed this year. The Bank of England (BoE) base rate is now 3.5%. Some analysts see the base rate hitting 4% in 2023. But it could even higher.
And that’s positive for Lloyds in two ways. Firstly Lloyds, like other banks, isn’t perfectly passing on higher lending rates to savings customers. And therefore the NIM is predicted to reach 2.9% by the end of the year.
But there’s another multi-billion pound tailwind. Analysts have highlighted that for every 25 point basis hike, Lloyds will earn around £200m in income from reserves held with the central bank.
As of June 30, Lloyds had £145.9bn of eligible assets with £78.3bn held as central bank reserves. And the BoE base rate has already risen 325 basis points this year. So it’s a near-£3bn tailwind so far.
This is a huge boost for revenue. And as Lloyds doesn’t have an investment arm, its interest rate sensitivity is higher than its peers.
How long can it last?
Forecasts vary for the BoE base rate. It’s currently at 3.5%, but inflation is still at levels not seen before in my lifetime. The UK’s annual inflation rate is 10.7%, that’s far above the BoE target of 2%.
So how high will interest rates go? Well, the BoE forecasts it could reach 5.2% in the fourth quarter of 2023, before falling to 4.7% in 2024 and 4.4% in 2025. But this, or course, is all dependent on inflation.
Other organisations have their own predictions. For example, Scotiabank is more dovish. It forecast the UK’s key interest rate to rise to 4.25% in 2023, and decline to 3.25% in 2024.
But the headline is that rates are likely to rise further, and this will increase Lloyds’ earnings on central bank deposits. And it looks like the BoE interest rate will remain sizeable over the next two years.
It’s also likely that a hedging policy could push some of the benefits further into the future.
So despite the ongoing recession and higher impairment costs, I believe Lloyds is set to reap the gains of interest interest rates for some time. That’s why I’m hanging on to my shares.
