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If interest rates hit 4.5%, what could happen to the Lloyds share price?

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Last week, the Bank of England increased interest rates by 0.75%, putting the base rate at 3%. It doesn’t appear that the central bank is finished yet. Market expectations are for another 0.5% increase from the December meeting. Some are forecasting the rate will hit 4.5% next spring. Given the sensitivity to this for Lloyds Banking Group (LSE:LLOY), it got me thinking. If rates do hit these highs, what does it mean for the Lloyds share price and should I buy?

Why high interest rates help the bank

On one side, it could serve as a benefit to the bank. Consider what was reported in the latest Q3 results. It mentioned “robust revenue growth supported by continued recovery in customer activity and UK Bank Rate changes”. The changes helped to improve net interest income by 15% on the same period last year.

There are two key elements I need to understand, the net interest margin and net interest income. The margin refers to the difference (as a percentage) that the bank earns from lending out money and paying out money for deposits. If the bank pays on average 1% on deposits but charges 3% for a loan, the margin is 2%.

For Lloyds, the margin was 2.98% in Q3. If we rewind to the start of the pandemic when the base rate was cut to 0.1%, the net interest margin for Lloyds was clearly much lower.

Net interest income is how much money the bank generates due to the margin. It’s a key stream for the bank, generating £3.3bn in Q3 alone.

Naturally, if the interest rate continues to rise to 4.5% next year, this is going to filter down to a higher net interest margin for Lloyds (and other banking stocks). This should help to boost income and profitability. Both should support the share price moving higher.

Caution required

Given the increase in interest rates already this year, why is the Lloyds share price down 12% over the past 12 months?

One factor here is the concern some have for the UK economy. Higher inflation and energy issues have caused a cost-of-living crisis. This is bad for a bank because consumer spending dries up and loan defaults increase.

The latest results included a comment that “the current environment is concerning for many people”. If interest rates continue to increase, this is only going to make things worse for borrowers. For example, it will make it harder to pay the mortgage.

This could mean that the Lloyds share price will struggle to move higher next year. The stock is a barometer for the UK economy. If we stay in recession, the urge to buy the stock might disappear.

I think that higher rates will ultimately be a positive for Lloyds shares. However, I also think a good amount of the boost will be eroded by weak consumer sentiment. Therefore, I struggle to see enough of an opportunity for me to want to buy right now.

The post If interest rates hit 4.5%, what could happen to the Lloyds share price? appeared first on The Motley Fool UK.

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Jon Smith has no position in any of the shares mentioned. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.