Why the Latest Unemployment Data Is Such Good News for Bank of America

By John Maxfield Markets Fool.com

Image source: iStock/Thinkstock.

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On the first Friday of every month, the U.S. Labor Department publishes the official unemployment rate for the previous month. The latest reading was positive, which will ratchet up pressure on the Federal Reserve to increase interest rates and thereby spur revenue and earnings at Bank of America (NYSE: BAC).

The Labor Department said today (here's the official press release) that the unemployment rate in the United States fell to 4.6% last month. That's incredibly low. The last time it was that low was in August 2007, near the heights of the pre-financial crisis housing bubble.

Data sources: Federal Reserve of St. Louis and U.S. Labor Department. Chart by author.

Why low unemployment is good for banks

The significance of this for bank stocks, Bank of America in particular, can't be overstated. One of the main ways banks generate revenue is by making loans. The problem they've faced over the past few years, however, is that interest rates are essentially as low as they've ever been, which reduces the yield on a bank's loan portfolio.

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The Federal Reserve has kept interest rates low in an effort to boost the economy -- to "provide accommodation" in the official vernacular. More specifically, under the central bank's congressional mandate, the Fed is responsible for minimizing unemployment and inflation.

With an unemployment rate of 4.6%, down from 4.9% in October, it has more than accomplished the first of these objectives. Moreover, with inflation expectations ticking up, evidenced by the sharp rise in the interest rate on 10-year Treasury bonds (interest rates and inflation tend to go hand in hand), there's bound to be a growing chorus of support at the Fed to raise rates at its meeting this month.

Fed Chair Janet Yellen has essentially said as much. Testifying before Congress in November (here are her prepared remarks), Yellen said that interest rates could rise "relatively soon" if the economy continued to recover: "At our meeting earlier this month, the Committee judged that the case for an increase in the target range had continued to strengthen and that such an increase could well become appropriate relatively soon if incoming data provide some further evidence of continued progress toward the Committee's objectives."

Suffice it to say that the latest unemployment figures certainly provide "further evidence of continued progress."

An important nuance to keep in mind

Now, it's worth pointing out that the official unemployment rate doesn't capture a number of nuances that make the employment picture seem less optimistic. This is because it excludes people who don't have jobs and aren't actively seeking jobs from the calculation. Consequently, if a lot of people have gotten discouraged and stopped looking for jobs, then they aren't considered unemployed for the purposes of the official unemployment rate.

This was the case last month for more than 400,000 people who voluntarily stopped looking for work. By contrast, the economy added a net 178,000 jobs last month. The reason the unemployment rate dropped so far, in other words, isn't because a lot of new jobs were created, but rather because people dropped out of the active labor force, lowering the labor-force participation rate.

In fact, if you include people who aren't actively seeking work, or people who are working part-time but would rather have a full-time job, then the unemployment rate in November was 9.3%, down from 9.5% the previous month.

Either way, though, the important thing to appreciate is that the data is moving in the right direction, which is very good news for banks. As I've noted ad nauseam over the past few months, if interest rates rise a mere 100 basis points, or 1 percentage point, Bank of America stands to generate $5.3 billion in additional net interest income -- that is, on top of the roughly $40 billion in annual net interest income that it already earns.

This is high-margin revenue because it doesn't require Bank of America to do anything new to generate it. It doesn't have to hire more workers, build new branches, or invest in technology. It can just continue doing what it's already doing -- making loans -- and it'll make more money doing so. As a result, most of this revenue, less corporate income taxes, should fall to Bank of America's bottom line.

To complete the circle, then, higher interest rates should further increase the value of Bank of America's stock, which is dictated in large part by the bank's profitability. Along these same lines, it will make it easier for Bank of America to boost its dividend next year.

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John Maxfield owns shares of Bank of America. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.