The UK bank best placed to benefit from rising interest rates

Interest rate hikes are typically good news for bank sector margins, but share prices haven't responded yet. This expert believes investors are underestimating bank's gearing to higher interest rates.

A rate rise cycle that was supposed to have lifted shares has instead left Lloyds Banking Group (LSE:LLOY) 4% cheaper than where it was prior to December’s first Bank of England hike.

Despite the expected margins boost from higher interest rates, fears over credit quality and the impact of a looming recession on a stock closely tied to the UK economy have dampened sentiment to leave Lloyds shares trailing at 42.5p this afternoon.

The widely-held stock fell 1.5p today, a decline that accelerated after the Bank of England produced a more measured approach to fighting inflation than US counterparts after the Federal Reserve yesterday delivered a 0.75 percentage point increase.

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The UK base rate is still at a 13-year high of 1.25%, however, after five consecutive increases by the Bank’s monetary policy committee, with potentially more to follow.

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NatWest Group (LSE:NWG) is regarded as the lender best placed to benefit from rising interest rates, although its shares are still only 2p higher than when the base rate stood at 0.15% on 15 December.

The former Royal Bank of Scotland company is the preferred UK domestic bank pick of Bank of America, which also believes that Lloyds is attractively priced.

In a note this week, Bank of America analysts said: “We believe that the market underestimates both the credit resilience of banks' lending and their gearing to higher interest rates.”

They expect mortgage rates to hit 3.7% by early 2023 as lenders continue to rebuild spreads to more acceptable levels after years of ultra-low interest rates.

Despite the eventual doubling of mortgage rates, the bank does not see major affordability issues: “These are big increases but borrowers are in a strong position. They spend significantly less of their income on mortgage payments than before the financial crisis, even with much higher capital repayments.

“Households have been deleveraging for more than a decade, compared to rising debt to income levels previously.”

Yesterday’s note also points out that higher interest rates take time to impact borrowers, with 95% of new lending on fixed rates since 2017 and over half now fixed for at least five years.

Income growth and capital repayments made during this time should also limit the increase in the proportion of income spent on mortgage payments, the bank said.

Higher mortgage rates have the potential to derail the house market, but the bank expects prices to slow rather than correct unless there's a significant deterioration in unemployment.

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For now, the jobs market remains robust and the balance sheets of lenders are significantly stronger than have been in the past to withstand a surge in defaults.

Bank of America yesterday had “buy” recommendations and price targets on Lloyds and NatWest of 57p and 360p respectively, compared with levels of 42.5p and 218.9p this afternoon. Barclays (LSE:BARC) has a target of 180p, against 155.1p today, while FTSE 250-listed Virgin Money UK (LSE:VMUK) is rated at 175p compared with 127.3p currently.