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Following the continuing high UK inflation in April, the forecast interest rate for later this year has risen again. With the current rate of 4.25% and pretty much a nailed on 0.25% rise in May, some in the market are now expecting the rate to hit 5% before the end of the year. Given the sensitivity to this of the Lloyds Banking Group (LSE:LLOY) performance, what could this move mean for the Lloyds share price?
Higher rates are good for the bank
To be clear, the bank benefits from higher interest rates. The core operation of a retail bank like Lloyds is to pay interest on deposits and charge interest on loans. The difference in the rate paid and the rate charged is known as the net interest margin. The higher the Bank of England base rate is, the larger this margin becomes. A higher margin means larger revenue and more profit.
The benefits of the sharp rise in rates over the past year have already shown evidence of this. In the Q4 results, profit before tax hit £1.8bn, up 80% year-on-year. The important net interest margin was reported at 3.22%. For comparison, at the same time last year it was 2.57%. This is a large jump and reflects the enhanced interest rate.
The 6% rise in the Lloyds share price over the past year might not be as much as investors were expecting based on the above. Yet the sector has dealt with problems, such as the recent demise of Credit Suisse and Silicon Valley Bank. With trust shaken, the fact that Lloyds shares are still up is a good thing.
Dangers of 5%
Some might think that the share price should rise even further over the coming year if a 5% base rate is seen. This isn’t necessarily the case.
There’s an inflection point whereby if interest rates go so high, the economy is forced into a recession. This is because it becomes too expensive for people to pay mortgages and other loans. It also makes people save money to get the high interest rather than spend. This is bad for business and can see growth slowdown.
In this case, Lloyds stock could fall, as default rates for loans increase and the outlook worsens.
Finding the balance
As we currently stand, 4.25% seems high enough for the bank to continue to make good income but shouldn’t push the UK into a recession this year (according to the latest forecasts).
There’s a chance that even at 5%, the economy can cope. Sure, Lloyds will have to set aside some provisions for loan losses. But this will be more than offset by the higher income, and should act to increase the share price.
Nobody knows exactly what the tipping point will be for the UK. My gut feeling says that 5% is going to put pressure on the bank. On that basis, I think a smart play is to steer clear of Lloyds and instead buy more international banks such as HSBC and Standard Chartered. These are less exposed to the UK in case things go pear-shaped.
