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Why Higher Interest Rates Are Good for Bank Stocks

The Federal Reserve has raised interest rates in both of the last two Decembers, and it seems prepared to do so again next month. There's a 97% chance of that happening, in fact, according to the CME Group's FedWatch Tool.

This would be music to the ears of JPMorgan Chase (NYSE: JPM) and other banks, which make more money when interest rates are high than when they're low.

To understand why, it's helpful to think about a bank as a retail store. But instead of selling clothes or books, a bank sells money. It does so by making loans, the price of which is reflected in the interest rate. As the price of money increases, a bank's revenue follows suit.

Image source: Getty Images.

Interest-rate sensitivity

Banks disclose their interest rate sensitivities each quarter, showing how much their revenue (in the form of net interest income) changes given a set change in interest rates. In JPMorgan Chase's case, the bank provides an analysis of two different interest rate scenarios.

The first scenario assumes that short- and long-term interest rates increase instantaneously by 100 basis points, or 1 percentage point. In this scenario, JPMorgan Chase would make $1.9 billion more from its portfolio of loans and interest-earning securities. If rates rose by twice that amount, or 200 basis points, then the bank's net interest income would be $2.9 billion higher than it otherwise would be.

The relationship holds true in reverse. If rates were to fall by 100 basis points, JPMorgan Chase forecasts that its net interest income will fall $4 billion.

The Federal Reserve's headquarters in Washington, D.C. Image source: Getty Images.

Watching the Fed

The thing to watch right now when it comes to interest rates is the Federal Open Market Committee meeting in December. That's a committee of Federal Reserve governors who get together eight times a year to decide whether to raise or lower interest rates.

The committee does so by targeting the federal funds rate, which you can think of as the rate that banks lend money to each other on an overnight basis. It's a very low rate, especially in the wake of the financial crisis, at around 1.16% today.

The fed funds rate is the primary short-term interest rate benchmark in the United States. If it goes up or down, so too will other interest rates, including lending rates. This is why, when the Federal Reserve wants to cool down the economy, it raises interest rates.

It remains to be seen if the Fed will do so at its next meeting, but there are reasons to believe it will. Unemployment is at 4.1%, which is well below the Fed's target rate of 5%. And inflation has trended higher for three months in a row. These fit the central's bank's dual mandate, which is what it uses to direct monetary policy.

Consequently, if the Fed decides to do so, this is why banks, and thereby their shareholders, would benefit.

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