I have to admit, when I saw an article published on Thursday that noted bond traders were now pricing in UK rates to hit 6.5% next year, I spat out my tea.
Granted, I feel the base rate of 5% is likely going to increase further this year. But 6.5%? That’s beyond even my worst-case expectations.
Yet when it comes down to Lloyds Banking Group (LSE:LLOY), higher rates should be a good thing. So what could the rate at 6.5% mean for Lloyds shares?
Enjoying the benefits so far
The Lloyds share price is up 5% over the past year, and I feel most of this has been driven by the move in interest rates over that period. The higher rates have allowed the bank to become a lot more profitable.
To understand this correlation, we need to strip the bank down to the basics. It takes money from a depositor and pays interest on this. It then takes the money and lends it out, in the form of a loan, mortgage or something else. It charges for this. The difference between the deposit rate and the loan rate is the net interest margin.
The higher the base rate, the larger this margin becomes. The banks don’t usually increase the deposit rate by as much as they bump up the rates on loans. In fact, the FCA is investigating this at the moment due to cries of foul play.
Whatever the case, it has helped Lloyds. When I compare Q1 2022 to Q1 2023, profit after tax jumped from £1.1bn to £1.6bn. Underlying net interest income was up 20% in Q1 2023 versus the previous quarter.
Starting to get a little worried
I remember writing at the start of May about my concerns that pushing the interest rate above 5% could start to hurt the share price. This is because there comes a point at which high rates damage the consumer and the economy.
If rates are so high that people can’t pay their mortgage, finance a car, etc then it’s going to negatively impact financial performance for Lloyds. Don’t forget, this is the largest bank in the UK for retail clients. So it’s going to feel the hit more than others in the sector that have large investment and corporate bank divisions.
If 5% was my point of inflection back in May, 6.5% is something that I feel is going to have bad consequences. In fact, as rate expectations have continued to rise over the past month or so, Lloyds shares have fallen. Over the past month, the stock is down 4%. I feel some of this is coming from investor concern.
How I’d play it from here
Of course, there’s no guarantee interest rates will rise as high as 6.5% in the coming year. Yet we’re already at 5%. I struggle to see Lloyds outperforming in the second half of this year, so would steer clear right now.
However, if we see a sharp sell-off below 38p to fresh 52-week lows, I’d be more inclined to consider buying for the long term.
