Bank stocks ignored this week’s rate cut. Get used to it

Canadian banks have a new tailwind: Falling interest rates should spur loan growth and provide relief to stressed homeowners and businesses, who may find it easier to repay loans.

But it’s not clear that a shift in monetary policy, which began this week, will lead to a fresh rally in bank stocks right away.

In an ominous early sign, the sector failed to ignite Wednesday, after the Bank of Canada cut its key interest rate by a quarter of a percentage point and signalled additional cuts if inflation continues to ease.

Bank stocks, on average, fell 0.2 per cent and underperformed the S&P/TSX Composite Index by nearly a full percentage point. They lagged the benchmark again Thursday.

Same old, same old. Since the start of the year, the sector has underperformed the benchmark by about 3.5 percentage points, not including dividends. That extends a weak streak that began at the start of 2022, when rising inflation pushed global central banks to raise their key interest rates aggressively.

Curiously, rising rates initially offered an upside for banks: Lenders could charge more interest on loans than they paid on deposits, fattening their profit margins.

But this initial enthusiasm collapsed as investors recognized that inflation was sticky, rates were headed higher than expected and borrowing costs were rising to the point where they threatened the economy.

Bank of Montreal reflected these simmering risks in its latest quarterly financial results, released May 29. The lender reported $5.3-billion in gross impaired loans, an increase of 98 per cent year-over-year. The stock fell 8.9 per cent on the day BMO delivered this news.

Now, investors are facing a new era of monetary policy, where rates decline as inflation subsides. If rising rates failed to send Canadian bank stocks higher, will falling rates do the trick?

Observers expect the Bank of Canada will continue to cut interest rates this year. Economists at Canadian Imperial Bank of Commerce, for example, expect another three cuts by the end of the year, totalling three-quarters of a percentage point.

On Thursday, the European Central Bank cut its key rate for the first time in nearly five years. Other central banks may follow, including – eventually – the U.S. Federal Reserve, reinforcing the downward trend.

That could be good news for Canadian bank stocks over the long haul. Their attractive dividends may again outshine yields on GICs and other income-generating assets.

In theory, Canadians could clamour for new loans as borrowing costs decline, providing a boost to lending activity that stagnated in the banks’ fiscal second quarter, compared with the first quarter. Upbeat lending should help profits, too, which also didn’t budge during the latest quarter.

However, there are several hurdles in the way of a sustainable rally.

The first is the most obvious: The Canadian economy is limping, hardly a bullish backdrop for a sector that essentially reflects economic activity.

In the first quarter, Canadian gross domestic product expanded by just 1.7 per cent at an annualized pace, well below the Bank of Canada’s estimate of 2.8 per cent and low enough to raise questions about how the economy will fare throughout the year.

Second, inflation was last observed at 2.7 per cent, which could be high enough to make the Bank of Canada cautious about cutting rates too aggressively.

If inflation proves sticky in the months ahead, interest rates could remain higher for longer. That could put a damper on loan growth, especially if the Fed is slow to introduce rate cuts of its own.

Third, Canadian banks are dealing with other issues that are weighing on their share prices.

Toronto-Dominion Bank is facing U.S. regulatory scrutiny over its anti-money laundering practices, hampering growth. Bank of Nova Scotia is trying to engineer a strategic turnaround. And some observers believe the Canadian housing market is a bubble that could burst, raising concerns about the potential impact on all lenders.

Lastly, despite their underperformance, Canadian bank stocks are hardly cheap or beaten up, which could limit rallies from here.

On average, the sector is down 15 per cent from its record high in 2022. More importantly, though, it is up 23 per cent from its recent low last October, when a bond market rout spilled into the stock market and threatened the economy.

Perhaps the gains since then were early bets that the Bank of Canada would cut its key interest rate this year. If so, investors should now be asking what happens next. The answers are anything but clear.