New York | Next week we launch the first paid product for The Institutional Risk Analyst, "The IRA Bank Book," which will feature our concise thoughts on the US banking industry and credit markets, along with some pretty charts to illuminate the discussion. More on this soon.
This week the markets await the first press conference of Federal Reserve Board Chairman Jerome Powell, a tribal ritual that brings together the media, investors and policy makers in a shared experience of confusion, accidental misstatement and deliberate obfuscation.
The question we all ask is whether the Federal Open Market Committee will raise targets for short-term interest rates a quarter of a percentage point? Or More? How soon?
But the question that we ought to ask is this: How long will it take for the narcotic effect of central bank market intervention to wear off? And what happens to market volatility as the end of official suppression of rates and credit spreads slowly plays out. Will there be lumps in the proverbial gravy train on Wall Street? Yeah…
"We make linear forecasts but in reality, interest rates, corporate profits and exchange rates—all crucial measures of return in their markets—are actually nonlinear series,” writes our friend John Silvia, Chief Economist of Wells Fargo & Co (NYSE:WFC). “This is an important challenge to how we think.” Indeed, the biggest challenge facing market analysts is to ignore the linear data that overwhelms our senses and focus on the random nature of markets.
Consider the idea of record bank profitability, a theme repeated over and over again by the financial media. But is this true? One of the things we focus on in the inaugural issue of "The IRA Bank Book" is whether the US banking industry is really profitable given the huge disparity between the rising interest earnings of banks and the still tiny, heavily subsidized cost of funds for the industry.
One of the costs for consumers of central bank intervention has been the transfer of trillions of dollars in income from savers to debtors such as banks over the past decade. In Q4 2017, the total interest expense of all US banks was just $21 billion, but banks made $150 billion on total earning assets at the end of 2017.
A decade ago, the interest expense of a smaller US banking industry was $100 billion vs $180 billion in income. Today adjusted for the 33% growth in total bank assets, US banks should be paying well more than $100 billion on various sources of funding, from deposits to short-term borrowing from other banks to bond investors.
With the net interest income of banks at $107 billion last quarter, how much of bank earnings disappears in a rising rate environment? (Q: Do you think investors or journalists can get their minds around the idea of shrinking NIM in a rising interest rate world?) If we simply return to the net interest income spreads of a decade ago, that implies a shrinkage of $25 billion in net interest income for US banks as rates rise. Much depends on how fast deposit rates rise. Just saying.
Meanwhile, away from the relatively blissful world of banks, bonds and borrowed money, the world of global equities and perceived volatility is starting to evidence increased stress. After years of a 100% correlation between stocks and bonds, rate movements are beginning to impact the direction and magnitude of stock price moves.
How this process of “normalization” proceeds and at what pace are the imponderable questions. But to John Silvia’s earlier observation, neither equity markets nor bonds follow a linear pattern. Instead, global markets tend to follow a change pattern closer to entropy, where the inefficiency of market understanding and reaction in terms of asset allocation tends to make investors lag events as a matter of course. Even with massive amounts of data, the gap to understanding and then action is considerable and largely random. And this random quality is present both for policy makers and investors, raising interesting questions as to systemic risk events.
“The main problem with entropy uncertainty models is that they are used to justify the notion that there’s room to push agendas to the limit line of the outer edge of the envelope that supports the policy maker’s cognitive bias,” opines Dennis Santiago, Senior Managing Director for Compliance and Analytics at Total Bank Solutions. “It’s a rubber band. It’ll snap.”
Even with the sharp rise in equity market volatility in early February, many market participants are still groggy after years on maintenance medication c/o the FOMC. An important indicator of changing market perception is corporate credit spreads, which are starting to widen as uncertainty regarding interest rates and the economy grow, as shown in the chart below. The smarter money is already rolling out of equities into the safety of short duration credit, but the broad market still underestimates the possible rate of acceleration in volatility.
“Active equities investors were slower to react to last week’s ‘signal’ in momentum ‘reversals’ and defensive / ‘duration-sensitive’ leadership—as such, much more ‘deer in headlights’ yesterday than rest with Long-Short Beta to Nasdaq at the 86th percentile,” writes Charlie McElliott at Nomura. Note to readers: You don’t want to be the deer in the headlights.
There are some analysts who believe that Chairman Powell and his colleagues on the FOMC may try to get ahead of the curve and increase rates by more than 25 basis points when the Fed next moves. Powell is in the difficult position of having to remedy the slow pace of FOMC decision making under his predecessor.
Although a rise of 50bp is certainly justified by the available employment and inflation indicators, not to mention toppy stock and real estate prices, accelerating the normalization process via Fed action may have a very unpleasant impact on investor perceptions, volatility and most important, credit spreads.
Our biggest worry heading into the end of Q1 2018 is that the artificial stability engineered by the Fed is going to snap again, but on a larger scale and more lasting basis than we saw in February. In the event, credit spreads will widen, loss rates on loans and credit products will accelerate, and the US economy may slowly slip into a stall. Fed Chairmen tend to start their terms with a financial crisis and the migration back to normal may be very rough indeed.