It’s been a rocky past week for investors as we try to come to terms with the sharp moves in UK assets. The plunge in value of the British pound in recent days has meant that economists are calling for larger interest rate hikes from the Bank of England. This could put the base rate around 4% by the end of this year. Even though this is bad news for some stocks, here’s why I think it could actually help the Lloyds Banking Group (LSE:LLOY) share price.
Boosting the net interest margin
The core reason why high interest rates help a bank to be profitable is because they increase the net interest margin. I look at it this way. A bank is a place where I can earn money from my deposits but have to pay an interest rate on my mortgage and other loans. If I make 1% on my deposits but pay 3% on my loans, the bank is making a margin of 2%.
When the base rate was lower, the margin for Lloyds was smaller. But with a higher rate, the bank can squeeze out more earnings.
I can already see how Lloyds has benefited financially from this in 2022. In the half-year report, it said the net interest margin grew to 2.77%. Guidance for the full-year was increased to 2.8%. This doesn’t seem like a large jump. But when we’re talking about billions of pounds, even a small increase can have a large impact on profitability.
The outlook is still increasing
The half-year results were released back in July. Since then, we’ve had two more interest rate hikes of 0.5% each. If the forecasts for a year-end rate of 4% are correct, I think Lloyds will exceed even its upgraded guidance.
Even though some investors have likely bought Lloyds shares in anticipation of this outlook, a trading update that would highlight this could see the share price jump even more. I think this is likely over the course of the next month or so.
Obviously, there will come a point when the central bank will decide the interest rate is high enough. It might even need to cut the base rate to help support the economy. Yet I don’t think this will be the case for another year, given the current concerns around the value of the pound.
Benefits for the share price
Finally, I think the share price could rally as higher interest rates see income investors flocking to buy the stock. Fundamentally, higher interest rates should support higher profits for the bank. And it has made its strategy clear by increasing the dividend per share payout in the last few results updates.
With a dividend yield of 4.48%, I think further increases could make it a more popular dividend option for investors.
I should note that interest rates are just one component of what influences the stock. Profitability could be negatively impacted from higher loan defaults or lower mortgage applications. I need to have a rounded view of the bank, not just relying on interest rate news.
I’m going to see what happens in coming days from the Bank of England but will most likely use some free cash to buy Lloyds shares.
