Why the Big Bank share prices have been crunched and what it means for the ASX200

For the second time this week, the ASX200 has fallen over 100 points, closing at 7019.70 (-1.42%).

The sharp fall comes after another day of carnage in financial stocks, with the sector now down over 8% this week, its largest decline since the onset of the pandemic when it fell ~45% in five weeks.

The rerating of the sector has accelerated after the RBA surprised the market on Tuesday by raising the official cash rate by a larger than expected 50bp from 0.35% to 0.85%.

It was the RBA's first 50bp hike since February 2000 and now signposts the start of a more aggressive rate hiking cycle that is expected to see the RBA take the cash rate above 2% by year-end.

Coincidentally the start of the RBA's more aggressive hiking cycle on Tuesday coincided with the Australian consumer confidence falling to its lowest level since Mid-August 2020.

The catalyst for the fall in consumer confidence is cost of living pressures and the prospect of higher interest rates.

Consumer confidence is set to fall again next week after a deluge of adverse reports this week around higher gas and electricity bills, softening housing prices, and higher mortgage repayments.

In Australia, household consumption accounts for approximately 50% of GDP, considerably lower than the 70% it accounts for in the U.S.

Nonetheless, household spending is still a key driver of the Australian economy. When consumer confidence falls, it leads to softer household spending and lower economic growth. For this reason, it is viewed as a leading economic indicator.

What do higher interest rates and falling consumer confidence have to do with bank share prices?

In general, banks face interest rate risk due to the nature of their activities, whereby they fund longer-term assets (loans) with shorter-term liabilities (such as deposits and wholesale debt).

Here in Australia, financial institutions hold very little direct exposure to changes in interest rates due to the composition of their balance sheets and regulatory incentives to hedge remaining interest rate risk. As a side note, funding costs can vary considerably in times of dislocation.

Most of the bank's interest rate risk comes from customers and policy holders via loan impairments and demand for financial services.

And this is where things get interesting.

Growth in housing credit has picked up in recent years, alongside the strong growth in housing prices. However, higher interest rates reduce demand for credit, a key driver of bank profitability.

This is because higher interest rates reduce housing affordability. This, in turn, leads to softening in housing prices such as the one currently unfolding in Sydney and Melbourne.

Elsewhere a decline in consumer confidence can lead to lower spending, which can very quickly put a handbrake on economic growth. In a simplified world, this leads to job losses which in turn leads to households falling behind in their payments and a reduction in the quality of banks' loan books.

The final consideration is housing loans account for approximately 50-55% of a bank's assets here in Australia. So when house prices fall it provides a headwind to share prices from that aspect as well.

What comes next?

As can be viewed on the chart below, the ASX200 Financial Sector has today tested support at 6000 and held. As can also be viewed, a textbook double top at 6956 and double bottom at 6000 has contained the Financial Sector for the past nine months.

A sustained break below 6000 would be a very big deal for the financial sector and the ASX200, given its chunky ~25% weighting within the index.

Source Tradingview. The figures stated are as of June 9th 2022. Past performance is not a reliable indicator of future performance. This report does not contain and is not to be taken as containing any financial product advice or financial product recommendation

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