The Federal Reserve Just Signaled That Higher Rates Are on the Horizon

If you want to know which way interest rates are headed, one of the first places you should look is the Federal Reserve's dot plot. This isn't as well known as the yield curve, but it's nevertheless important, particularly right now.

Understanding the dot plot

The dot plot isn't complicated. The vertical axis rises in quarter-point increments from 0% up to 5%, representing the target level for the federal funds rate, the principal short-term interest rate benchmark in the United States. The horizontal axis, meanwhile, represents years 2017 through 2020 and beyond.

There are 16 dots per year, with each one representing an individual member of the Federal Open Market Committee's interest rate forecast for that period. In 2017, for instance, there are 11 dots between 1.25% and 1.5%. By next year, the plurality of dots is between 2% and 2.25%, while over the longer run, the plurality settles at 3%.

The Fed released its latest dot plot this week (above), providing two important takeaways. First, it seems increasingly likely that the Fed will raise interest rates one more time before the end of the year. It would be the third hike of 2017, as well as the third December in a row that the central bank has hiked rates to end the year.

The Fed has been expected to do this for a while now, with CME Group's FedWatch Tool estimating a 75% probability that the fed funds rate will end the year at between 125-150 basis points, or from 1.25% to 1.50%. This corresponds to what the dot plot implies, given the 11 dots clustered in 2017 at just this range. Both suggest a 25-basis-point increase from the current level.

The second takeaway is that interest rates are expected to continue to climb for the foreseeable future. If everything goes as the Fed expects, rates should be a full percentage point higher by this time next year.

Good news for bank stocks

It remains to be seen whether interest rates will actually follow this path, but if they do, it'd be very good for banks' top and bottom lines, as well as their stock prices. You can see this by looking at banks' interest rate sensitivity analyses, which large banks include in quarterly regulatory filings.

In Bank of America's (NYSE: BAC) latest analysis, for instance, it predicts that a 100-basis-point, or one percentage point, increase in short-term rates will boost its net interest income by an additional $2.2 billion a year. And if both short- and long-term rates increase by that amount, Bank of America's net interest income would grow by $3.2 billion, holding all else equal.

The story is roughly the same for JPMorgan Chase (NYSE: JPM). The nation's biggest bank by assets expects that a 100-basis-point increase on both ends of the yield curve will translate into $2.2 billion in added net interest income. That's not as much as at Bank of America, which would see a similar boost from a rise in just short-term rates, but it's still a lot of extra cash that JPMorgan Chase could use to buy back more stock, return to shareholders by way of dividends, or to finance organic growth.

With this in mind, it doesn't seem like a coincidence that bank stocks are up this week, with both Bank of America and JPMorgan Chase shares up by nearly 4% relative to their closing prices last Friday.

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John Maxfield owns shares of Bank of America. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.