How Much Will Higher Interest Rates Help U.S. Bancorp?

U.S. Bancorp Tower in Portland, Oregon. Image source: Wikimedia Commons.

U.S. Bancorp (NYSE: USB) is the most profitable big bank in the United States, but that doesn't mean that it won't soon make even more money. In fact, the Minneapolis-based bank could see its earnings rise in the near future if the steadily improving economy convinces the Federal Reserve to raise interest rates.

Bank stocks and interest rates

When it comes to bank stocks, few questions right now are more important than if/when the Fed will boost rates. This makes sense when you consider that one of the main ways banks generate revenue is by selling money -- i.e., making loans -- the price of which is dictated by interest rates. Higher rates mean higher loan prices. And higher loan prices mean higher revenue for banks.

The relationship between interest rates and bank revenue has been problematic since the financial crisis. In the wake of the downturn, the Fed immediately dropped short-term rates -- the fed funds rate -- to near zero. Long-term rates soon followed.

This has been great for people who bought houses over this time period. For extended stretches during the past four years, the rate on a 30-year mortgage dropped below 3.5%. When you consider that the inflation rate is almost certainly bound to top 2% sometime in the near future, this means that the real (i.e., inflation-adjusted) rate to borrow money for many mortgagees could end up closer to 1.5% over the life of their loans.

Data source: Chart by author.

But the flip side of this is that banks aren't earning as much money from their loans as they once did. In 2006, U.S. Bancorp's loan portfolio yielded 7.04%. By last year, this had dropped to 4.06%. This is significant when you consider that U.S. Bancorp's loan portfolio throughout 2015 averaged around $250 billion. The 3-percentage-point difference equates to approximately $7.5 billion in annual interest income.

To be clear, U.S. Bancorp has continued to do incredibly well despite headwinds from low interest rates. Its return on average assets in the first nine months of this year was 1.37%, comfortably above even the notoriously highly profitable Wells Fargo, which reported a 1.19% return on average assets over the same period. And you could go through a host of other performance metrics that tell the same story.

Higher interest rates on the horizon

The good news for investors in U.S. Bancorp is that its performance could be on the verge of getting even better, as it seems almost certain that the Fed will raise rates either at its meeting this month, or soon thereafter. Fed Chairwoman Janet Yellen said as much in testimony to Congress in November (emphasis added):

We now have that positive "incoming data" that Yellen alluded to. Earlier this week, a measure of nationwide home prices finally eclipsed the pre-financial-crisis high. And just today, the U.S. Labor Department said that the unemployment rate last month dropped to 4.6%, down from 4.9% in October, and now well below the central bank's 5% target. There are nuances underlying the way the unemployment rate is calculated that paint a less rosy picture, but the data is headed in the right direction, even after accounting for these nuances.

Data source: Federal Reserve Bank of St. Louis, U.S. Labor Department. Chart by author.

The only thing that's kept the Fed from raising rates is the fact that inflation continues to come in below its 2% target. The latest reading showed an inflation rate of 1.6%.

But there's reason to be optimistic on this note, too. The post-election surge in the yield on 10-year Treasury bonds implies that investors expect a near-term rise in rates, given promises from the incoming administration to reduce taxes and increase infrastructure spending, both of which should serve as a tonic to the economy and inflation. Moreover, with oil prices potentially on the rise in the wake of an agreement to cut production between OPEC, Russia, and Iran, there could also be upward pressure on consumer prices, thanks to higher energy costs.

What will this mean for U.S. Bancorp? We have a pretty good idea, given that its quarterly filings with the Securities and Exchange Commission include interest-rate sensitivity analyses. In its latest report (see page 23), it estimates that a 50-basis-point, or half a percentage point, increase in short- and long-term rates will translate into a 1.75% boost to its net interest income. That equates to about $50 million on a quarterly basis and $200 million in added net interest income each year.

This isn't a game changer, so to speak, as U.S. Bancorp earns $1.5 billion a quarter in net income, but every bit counts. Moreover, the impact on its bottom line should be greater than 1.75%, as net interest income is high-margin revenue. U.S. Bancorp doesn't have to hire more employees or build more branches to benefit from the boost -- higher interest rates alone do the work. Additionally, there's every reason to believe that rates could soon increase by more than 50 basis points, as they already have on the long end of the yield curve.

In sum, while investors have no reason to lament U.S. Bancorp's performance right now or over the past decade-plus, there are plenty of reasons to think that things will nevertheless improve from here.

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John Maxfield owns shares of US Bancorp and Wells Fargo. The Motley Fool owns shares of Wells Fargo. 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.