Why Capital One Financial Rallied Today

Shares of Capital One Financial (NYSE: COF) rallied as much as 9.5% on Friday, before pulling back to a 5.6% gain as of 2:25 p.m. ET.

The tech-savvy credit card and auto lender reported earnings last night, showing a healthy beat of analyst expectations and a significant increase in net interest income. Investors cheered the results.

Net interest income inflects higher

Capital One delivered $10 billion in revenue in the quarter, up 7% year-over-year, and adjusted (non-GAAP) earnings per share of $4.51 per share, up just 1.3%. Still, both figures came in ahead of expectations.

Investors were likely encouraged by a big increase in the company's net interest margins, which increased from 6.70% in the prior quarter to 7.11%. That's a big jump for just one quarter, and bodes well that the company will be able to retain healthy margins.

Credit card and personal loan providers have seen their net interest margins compress during the Federal Reserve's rate-hiking cycle. This is because card companies generally raise their rates with a lag, while short-term deposit costs rise instantly. However, now that the Fed has just started to reverse course and lowered the federal funds rate in September, those trends are likely to reverse.

Capital One saw inklings of the benefits in the third quarter. The company was able to increase the yields on its loan portfolio from 12.66% in Q2 to 13.24%, but its deposit rates paid to customers only increased marginally, from 3.56% to 3.63%. Meanwhile, the company's allowance for credit losses and charge-offs, while up compared to the year-ago quarter, also slightly declined relative to the second quarter.

Capital One's results see a "soft landing"

Increasing margins and lower allowances for credit risk is a perfect combination, fitting in with the "soft landing" scenario many are anticipating for the economy. This is when inflation and interest rates decline, but without significant job losses associated with recessions.

This is all well and good for Capital One. The next big issue for investors is the state of its attempted acquisition of Discover Financial Services (NYSE: DFS), which is currently under intense regulator scrutiny and will likely be decided next year.

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Discover Financial Services is an advertising partner of The Ascent, a Motley Fool company. Billy Duberstein and/or his clients have no position in any of the stocks mentioned. The Motley Fool recommends Discover Financial Services. The Motley Fool has a disclosure policy.