An Unexpected Tenner

Story Highlights:

• Wells Fargo became the latest big bank to announce signs of profitability.
• Core banking businesses are benefiting from steeply positive yield curves around the world. And last week's easing of mark-to-market accounting rules doesn't hurt either.
• But many formidable risks to banking remain—the government will announce the results of stress tests at the end of the month, and many banks are still entangled in TARP.

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(Editor's Note: MarketMinder does NOT recommend individual securities; the below is simply an example of a broader theme we wish to highlight.)

Ever reach your hand into an old jacket pocket and come out with a $10 bill? It's not much money, but boy, is it exciting—a pleasant surprise. Wells Fargo became the latest big bank to find a tenner in its pocket Thursday, announcing surprising profitability in the first quarter. Other banks made similar announcements earlier this year, including JP Morgan, Citigroup, and Bank of America. Accompanying today's upbeat news, stocks moved higher, led by Financials.

So what does it all mean? After all, aren't banks supposed to be the economy's bane right now? There are likely a number of factors at play.

For one, strong core banking performance relies heavily on the yield curve, or distribution of interest rates from short to long. When the curve slopes upward, it means short-term rates are lower than long-term rates—the yield curve is positive. That's exactly where we are now. In fact, the yield curve is steeply positive—not just in the US either, but in all major regions around the world too. Banks can borrow short-term funds cheaply and lend them out on the long end for a healthy profit. And attractive rates overall—mortgage rates are near all-time lows—have increased demand for these highly profitable loans. Further, past quarters have seen bank write-downs erode earnings margins significantly. But an easing of mark-to-market accounting rules means further write-downs may prove unnecessary.

This is all good news, and in the short term we're seeing some recovering share prices. But many formidable risks to banks remain. For one, the government will announce stress test results later this month. The tests put banks through hypothetical worse-case economic scenarios to determine their viability. So far, the feds have indicated no bank will fail the tests, only to hastily follow up with the fact no bank could fail the tests—one way or another they'll be kept afloat. And that means, at the government's discretion, there may be forced write-downs or capital injections later this year, putting the banking sector at the mercy of the feds' conclusions and tactful communication. Given their track record so far, that's not too encouraging.

Further, many banks are still entangled in TARP from the first round of capital infusions. The government has a say in their business, and the feds haven't exactly been consistent in their messaging—alternately favoring punishment or assistance. There may be some more huffing from Congress and introduction of added stringent terms to come. (Though we note, the tax bill to recover executive bonuses has been set aside for now, proving cooler congressional heads sometimesprevail.)

We're encouraged core banking seems healthier—an economic recovery requires a functioning financial system. But bank stocks still face a stiff government headwind that could yet blow ill, adding to the volatile vicissitudes of the bear's bottom.