May 23, 2022 | Last week, JPMorganChase (JPM) CEO Jamie Dimon was rebuked by shareholders unhappy with the bank’s recent performance. JPM is down 25% YTD and was trading at 1.3x book value at the close on Friday, hardly a disaster. But Americans as a group are unwilling to accept such a poor short-term showing, this even though much of the apparent wealth creation of the past two years was entirely surreal.
In 2020 and 2021, the FOMC removed $8 trillion in duration from the markets, forcing up asset prices for all manner of equity in the process. Now that very act of asset price inflation is being reversed and threatens to destroy a large chuck of virtual wealth accumulated in the equity markets. Chinese tyrant Xi Jinping has already destroyed several trillion in equity value via the communist crackdown on Chinese tech firms, but the US is preparing to add a zero to that total of value obliteration in coming months.
American’s accumulated an addition $35 trillion in paper wealth between Q1 2020 and the end of 2021, writes Ben Steverman of Bloomberg News. But Americans have lost $5 trillion in the selloff so far, JPM estimates in a research note, and may lose as much as $10 trillion by the end of 2022, the bank reports. This downward adjustment in paper wealth tracks the estimate we published earlier, that Americans would have to give back at least 25% of the paper gains created by quantitative easing (QE).
Watching the unhappy reaction of Americans to slumping prices for stocks and crypto assets, it is almost as though they feel entitled to continuous share price appreciation. The FOMC, of course, tells us that inflation expectations have not yet become hardened among the broad public. Yet when people complain about the impact of rising interest rates on public company valuations it seems like they don’t understand why stock prices were rising in the first place.
Truth to tell, Jamie Dimon is not responsible for seeing JPM reach $172 per share last October and he is not responsible for the fact that the bank’s equity is nearing $100 as of Friday’s close. Financials are simply tracking the ebb and flow of liquidity into the financial markets. Share prices are falling as expectations for short-term appreciation fall and concerns about credit costs are rising in the minds of the more astute members of the audience. Our bank surveillance matrix is shown below:
Notice that crypto bank Silvergate Capital (SI) is the worst performer in the group, now below 2x book vs 12x book last March. Western Alliance Bancorp (WAL) is likewise under pressure due to plummeting residential lending volumes. More important, sector leaders such as American Express (AXP) and Raymond James Financial (RJ) are outperforming the rest of the group when it comes to downside risk. Perennial underperformer HSBC (HBA) is the only name that is still up for the year. The market gods do have a sense of humor.
Is this the re-entry point for US banks? Not for our money. We are pondering several fintech names as we noted in our comments last week, but we’ll let the banks ride for a while in terms of common equity exposure until the magnitude and timing of the swing in credit costs becomes more clear. Just as US equity valuations will now give back ground, other asset prices including real estate are likely to follow as the great reset gathers pace
One reader of the Premium Service of The Institutional Risk Analyst said last week:
"I am a very satisfied subscriber and appreciate and value your reports. Quite frankly, it has been your writing that has kept me from investing any of my clients wealth into bank stocks."
Now to be clear, it is not that we dislike bank stocks per se, but we are very cautious about investing in financials when the open market intervention of the FOMC, or lack thereof, is the key determinant in bank results. The Fed boosted short-term earnings with QE and suppressed credit expenses for lenders by boosting asset prices – all asset prices. Now we are reversing this process, but bank interest earnings remain 30% below 2019 levels. It is an open question when or even whether banks will be able to rebuild these revenues.
As we assess whether or not to re-enter certain names in financials, the key calculous involves first determining how run-rate revenues and earnings are likely to look as the FOMC raises interest rates and allows the system open market account (SOMA) to run off. Given that the Fed still has yet to start that latter process, we think that JPM’s estimate that we give back $10 trillion in paper wealth this year may be a tad low. Why? Because magnitude of the Fed’s folly is large enough to force a general price reset for many assets, this as living expenses are rising.
A number of readers were appreciative of the post we published about the mechanics of QE and, the opposite, quantitative tightening or QT (“Chairman Powell's Duration Problem”). Yet we still don’t think most analysts understand what the end of this “extraordinary” policy implies for equity market valuations. This confluence of open-market manipulation by the FOMC and falling asset prices suggests that deflation, not rising prices, is now the chief concern.
“Duration of UMB 2.5s was 4 when they were originated at 102,” notes mortgage veteran Alan Boyce. “Now they trade at 90 and the duration is 12.” Extend that comment from Boyce to the entire housing complex of some $15 trillion in residential and commercial assets, and you begin to understand the scope of the adjustment problem created by QE.
The extension of the duration of the Fed’s $2.7 trillion in mortgage-backed securities illustrates the dilemma facing the FOMC. As interest rates have increased, the “weight” of the duration on the markets has grown three-fold in just the past year. This change is forcing down securities prices and creating huge losses on the books of the central bank as well as investors in loans and MBS. The Treasury yield curve and swaps are shown below.
Note that dollar swaps are still trading inside of Treasury yields, a slight improvement over the past six months. Demand for dollar assets remains brisk, but notice that short-term swaps are at a premium, suggesting an excess of demand for risk-free collateral. This has implications for the economy and credit conditions.
Analysts have taken to comparing the present period to the 1980s, when former Fed Chairman Paul Volcker took up interest rates dramatically. The Federal Reserve board led by Volcker raised the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981. But this time is very different because of the grotesque size of the Fed's balance sheet.
Zoltan Pozsar is reported to have said: “Fed won’t be intimidated by asset price corrections, but rather emboldened by them to do more.” If that is the case, then we look to see a far deeper correction in asset prices as the Fed's pushes $30 trillion worth of mortgage risk exposure, measured by duration, down the throats of depositories and non-bank lenders.
The lenders that created residential loans in 2020 and 2021, for example, are short a put option to the owner of the home. The holder of the mortgage may pay off the loan at any time and without penalty. During the past two years, just about every mortgage loan in the US was in the money for refinance. The big question is whether the rush for safety will accelerate the timing of the reset in residential housing, which we still see as being at least 24 months off.
Since interest rates are rising, the mortgage loan made in 2020 is no longer in the money for refinance, so no problem. Right? But the lender is also long credit exposure to the borrower. As interest rates rise and asset prices eventually fall, these QE-era loans will trade at a sharp discount and the true credit profile of the borrower will come back into view. All of those FHA borrowers that migrated into conventional loans, for example, will show their true credit characteristics in a recession in 2023 and beyond.
Many loans made during 2020 and 2021 on the strength of rising asset value will now be re-priced to adjust for falling asset prices, whether we are talking about a home or crypto or margin loans on shares in Softbank (SFTBY) or Tesla Motors (TSLA). The reduction in the Fed's balance sheet is the largest ever margin call on equity exposures of all descriptions. And the FOMC has not even begun to shrink the SOMA, suggesting that calls last week about the end of the bear market may be a bit premature.
The mere suggestion of an end of growth in FOMC securities purchases has caused equity markets to crash. The FOMC “intends to reduce the Federal Reserve's securities holdings over time in a predictable manner primarily by adjusting the amounts reinvested of principal payments received from securities held in the System Open Market Account (SOMA). Beginning on June 1, principal payments from securities held in the SOMA will be reinvested to the extent that they exceed monthly caps.”
As the QT process begins in a week’s time, we expect to see the global money markets slowly tighten, especially when the Treasury returns to the markets for the next refunding operation. Production of mortgage-backed securities is likely to continue to fall as mortgage interest rates rise, thus the end of Fed purchases is likely to be a non-event in a dwindling market for risk-free collateral.
The return of duration to the money markets, as represented by the opportunity to earn a return via rising interest rates, has provided an alternative to stocks, real estate and other speculative assets. The opportunity to take returns off the table and exit into risk free assets at positive yields is likely to continue to attract additional flows out of equities in the near term. Medium to longer-term, look for signs of a correction in high-end home prices as a signal that a housing price correction has begun.
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