What if No Rate Cuts in 2019??
New York | This week we announce the release of The IRA Bank Book for Q2 2019, a publication of The Institutional Risk Analyst. In this issue we ask some important questions, including:
** Why is Capital One Financial (COF) a better comp for Citigroup (C) than JPMorganChase (JPM)?
** Why are loss rates for real estate exposures of US banks moving back into positive territory?
** Will funding costs for banks continue to rise even as long-term Treasury yields fall dramatically?
** And just when is Fed Chair Jay Powell going to admit that the past eight years of "extraordinary" FOMC policy did nothing for inflation but did embed future credit risk in financials?
Read and learn. Oh and we see no rate cut by the FOMC in 2019.
One chart we did not use this quarter in The IRA Bank Book bears inspection, namely the rate of change in growth rates for various types of bank deposits. We note that “the high rates of deposit growth seen in the 2010-2016 period during the Fed’s “quantitative easing” operations have now been replaced by low or even negative growth rates.”
We write in The IRA Bank Book Q2 2019:
“As Q2 2019 comes to an end, short-term money markets remain tight due to the fact that the FOMC continues to shrink the Fed’s holdings of securities. Because the US government is running a fiscal deficit, for every dollar of Treasury securities on the Fed’s System Open Market Account that is redeemed, a dollar of bank deposits disappears when the Treasury refinances the bond in the private markets. The deceleration in deposit growth is a matter of concern because new lending is ultimately a function of the availability and cost of deposits. In particular, the decline in non-interest bearing deposits has negative implications for bank net interest income and overall profitability.”
As we discussed on CNBC last week, the FOMC is still tightening policy. We believe that there is growing risk in the non-bank financial sector due to erratic moves in interest rates, the flat Treasury yield curve and the decline of carry in loans and financial assets. The culprit here is the shrinking balance sheet, which represents continued policy tightening by the FOMC.
As rates have fallen towards zero, the behavior of loan and securities markets reflects a level of volatility and demand caused by the lack of cash flow or "carry" on financial assets. We do not expect a rate cut by the FOMC this year, contrary to conventional thinking on Wall Street, but we do anticipate an end to the shrinkage of the System portfolio by September and with it a resumption of reinvestment of all bond redemptions.
We believe that it should be obvious to policy makers, regulators and investors that operating in a flat yield curve environment near the zero rate boundary is not the same as 20 or 30 years ago, when the cash flow off of financial assets was far more significant to asset returns and inflation expectations, one of the explicit policy goals of the FOMC.
Banks have different default rate targets for customers. The Fed has skewed these risk measures via QE. As credit metrics return to normal, so will loss rates. The growing stress we see in non-bank finance today, however, is nothing compared to the pressures that will be unleashed in 12-18 months when visible default rates start to rise.
The inflation of asset prices in stocks, bonds and loans has concealed a great many sins in the world of credit over the past decade. Eventually these hidden default events will surface and reflect their true economic value. And ground zero for the next crisis in mortgage finance will be, ironically enough, the the market for government guaranteed loans issued into the Ginnie Mae securities market.