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The Institutional Risk Analyst

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Macro-Markets: The Case for Stagflation

New York | Sometimes simple images are the most powerful. The chart below from FRED shows US real GDP change vs. the effective rate for Federal funds over the past five years.

Just imagine around Election Day in the US this November, if the Fed funds rate is above the last print in real GDP and the gap between two year Treasury notes and ten year T-bonds is just about nada. Bad for stocks, yeah. But then maybe we see a bond market bull rally because the Street remains so painfully short quality duration.

As major central banks turn off the Electric Kool Aid drip, we’ll find out soon enough whether the promise of growth is real in a world with equally real interest rates. This question of just how fast the US economy can grow without near-zero short term rates is really the first order of business when assessing macro market risk.

If you believe the dot-plots from the Federal Open Market Committee, we are almost assured to see the convergence of GDP growth rates and Fed funds. Question to Chairman Powell: Are you prepared to start explicit sales of securities from the System portfolio? The chart below shows the painfully slow decline in the amount of Treasury bonds and mortgage backed securities behind the Fed’s $4 trillion in excess reserves.

The consensus on the Street seems to be lower growth and higher inflation, but with little upward pressure on interest rates. The Mortgage Bankers Association, for example, has projected real GDP change slowly trending below 2 percent by 2020. If we do two more quarter point increases in Fed funds this year, then we get perfect stagnation with rising inflation, right?

Fact is, global growth is not particularly strong, as witnessed by the slow attrition of Sell Side firms over the past decade. UBS, HSBC, BNP, Merrill Lynch, Morgan Stanley (MS) and other second tier transactional players fled to the safety of wealth management after the 2008 crisis, but folks like Deutsche Bank (DB) pretended that 2008 did not happen. This lack of response by management eventually crippled Deutsche financially and led to the current situation, where one of the biggest banks in Europe may require state aid.

Last week, we saw Deutsche Bank retreat from the world of deal making and derivatives trading, and going back to an imaginary European commercial banking business. We saw former Goldman Sachs banker and now European Central Bank chief Mario “Whatever it Takes” Draghi make noises about possibly continuing with the ECBs disastrous experiment in “quantitative easing.” Then we ended the week with German Chancellor Angela Merkel holding hands with Donald Trump at the White House.

One observer commented to The IRA last week that perhaps Merkel was at the White House to discuss “Plan B” for Deutsche Bank, but this of course assumes that there was Plan A. It seems pretty clear that there has never been a real design for dealing with Deutsche at the corporate level.

Years of QE in Europe has decimated DB and other European universal banks. Just as in the US, the ECB’s bond purchases have suppressed bank earnings and loan pricing, and basically killed secondary market trading. Each day we hear further doubts raised about the prospects of synchronized global growth, if for no other reason than the level of indebtedness globally is growing faster than the underlying economy.

Global debt is now at $164 trillion, or 225% of GDP, the International Monetary Fund warns. The world is now 12% of GDP deeper in debt than it was at a peak debt cycle during the financial crisis in 2009, hitting a whopping $164 trillion, according to the International Monetary Fund.

Our friend David Rosenberg from Gluskin Sheff + Associates in Toronto likes to remind us that the growth of the past five years – both in terms of stock prices and GDP – has come to us c/o the Fed, ECB and Bank of Japan. Why this fact is not obvious to more people working in the equity markets is a source of wonderment to us. Our collective inner neo-Keynesian cheers for the impact of low rates on debtors, but forgets that banks and pensions and even individuals are savers as well.

It is pretty clear that the much anticipated surge in cash from tax cuts has not caused an upward surge in corporate investment. The Street has been trimming GDP estimates since January, which in turn “trickle down” into earnings models. And the economic prognostication chorus has certainly turned bearish in the last few weeks. Indeed, Rosenberg told the gathered audience at the most recent Grant’s Interest Rate Observer conference that upcoming market adjustments would lead to a resurgence of religious faith.

One place we can assure you there is no lack of tearful prayers is the world of financial institution treasury, where the prospect of a flat yield curve is seen as truly dreadful. Look at the US bank unit of DB, for example, and the gross spread on the half of the lending book deployed in real estate loans is a whole 311 basis points (bp).

The same measure at JPMorgan (JPM) is 361 bp. Wells Fargo (WFC) real estate loans? 391 bp. Bank of America (BAC)? 364 bp. Do you want to even hear Citigroup? A whole 263 bp gross spread on real estate loans according to the FDIC. With inflation currently at 2 percent, less funding costs, these banks are giving money away for nothing.

If you look at the real estate loan book at US Bancorp (USB), suddenly we are near 5 percent gross yield. How about Bank of the Ozarks (OZRK) at 554 bp? BBT Corporation at 432 bp? Get the idea ? The smaller banks have more pricing power for originating assets, but net loan yields overall are still constrained and barely positive in inflation-adjusted terms.

So here’s the big question we face: Has the FOMC effectively capped financial asset returns for the foreseeable future? That is, do all savers face years ahead where yields on securities are better than say the lows of 2012-2015, but not much higher than today? And do banks now face competition from the bond market even as pricing for loans and securities show little real upward pressure?

Our best guess is that the attempt by the Fed, ECB and BOJ to stoke inflation by stealing duration from the markets via QE has had the reverse impact, namely constrained asset returns and income – that is, carry – from the global investment book. We’ve discussed the impact of curve flattening on net-interest margins previously in The IRA ("Bank Earnings and Financial Repression").

If GDP slows as the FOMC continues to literally force short-term rates higher, market sentiment toward the weaker financials such as DB could become very dicey indeed. But the more important concern is how global equity investors react to the idea that inflation may be higher than GDP in the years ahead -- the classic definition of stagflation.


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