New York | Whenever interest rates rise, the amen chorus on Wall Street starts to warble about the benefits to banks and bank earnings. Stock prices rise But readers of The Institutional Risk Analyst know that it is credit spreads and not market benchmark rates that actually determine bank net interest income.
The chart below from our latest Premium Service profile of Bank of America (NYSE:BAC) illustrates the fact that gross spreads on bank loans and leases have been falling during the latest period of massive Fed bond purchases (aka “QE”). Also, asset returns generally at banks are in a downward spiral thanks to QE.
Investment managers, however, are not the only ones confused about interest rates. Philadelphia Fed President Patrick Harker, for example, seven days ago declared that the U.S. central bank may begin paring back its bond-buying program as soon as the end of this year. Later in the day Harker, whose appointment to that post came as a surprise to many, corrected his earlier outburst, but the damage was done.
The damage of the Harker Tantrum = 20bp yield move in the 10-year Treasury note in a week. Thanks so much Patrick. Suffice to say that the cash MBS outperformed the Treasury hedge by a lot. Unhappy TBA traders abound.
Not to be outdone, a couple days later, Dallas Federal Reserve President Robert Kaplan said he expects broad vaccine distribution to unleash strong economic growth later this year, allowing the U.S. central bank to begin to pull back on some of its extraordinary monetary support, Reuters reports.
These two bits of squawking by members of the FOMC caused markets to positively tremble. The 10-year Treasury note backed up nearly 20% in yield in a matter of days, causing many market commentators to questions whether the FOMC is actually in control of monetary policy. Note in the chart from FRED below how the Japanese yen weakens as the 10-year note rises in yield. That’s a hint. H/T Ralph.
Yesterday the Board of Governors rolled out Vice Chairman Richard Clarida, who now says Fed bond purchases will keep pace through the rest of the year. Clarida said he expects the central bank to maintain the pace of its asset purchases through the rest of 2021, CNBC reports. Yet back in November, Clarida had hinted at possible changes in the Fed's bond-buying program. Were Harker and Kaplan merely parroting his earlier comments?
Even after these corrections and amplifications, the confidence protection team at the Fed’s Board of Governors sent Vice Chairman Clarida out yet again, now stating emphatically that the central bank would not change policy until inflation had been at 2% for a least a year.
Just to make investors feel even more confident, the Board then unleashed Fed Governor Lael Brainard, the furthest left Fed Governor on the political scale. The former bank regulator from MD declared for all to see that the U.S. economy remains “far away” from the U.S. central bank’s goals of a healthy labor market and stable inflation. As a result, says Governor Brainard, the Federal Reserve will likely continue its bond-buying program for “quite some time.”
What all of this confusion illustrates is that having Fed governors and Reserve Bank Presidents airing their personal views to the market is not helpful. This is especially true when the course of US monetary policy as determined by all of the members of the FOMC is unlikely to change.
Call us old fashioned, but we think that former Federal Reserve Board Chairman Alan Greenspan had it right. The Chairman of the FOMC, Jerome Powell, should comment publicly on US monetary policy and other members of the FOMC should be silent.
The internal deliberations of the FOMC are confidential. Having Patrick Harker, Robert Kaplan or other Reserve Bank Presidents grandstanding for the media is inappropriate, causes confusion among investors as to Fed policy, and should result in disciplinary action by the Chairman. Likewise, Governor Brainard’s public musings are not particularly helpful either since her socialist views are unlikely to win a consensus on the FOMC.
The irony of this situation is that the Fed’s massive purchases of Treasury debt and mortgage-backed securities is actually tightening credit. While yes, QE does force down bond yields, it also removes collateral from the credit markets, inhibiting the functioning of the mortgage markets and other secured financing. Today the Street is awash in cash liquidity, but collateral is scarce. One day, we hope all of the PhD economists at the Fed will realize that cash and collateral are two sides of the same coin.
Even as the Harker Tantrum caused bond yields to rise significantly, this in clear opposition to the policy set by the FOMC, interest rates on MBS continue to fall under the weight of the Fed’s aggressive open market operations. The FOMC bought $1.5 trillion in MBS since the explosion of COVID from a lab in Wuhan, China. As the chart below suggests, yields on 30-year MBS were unaffected by President Harker’s erroneous comments of a week ago.
Indeed, as Q4 2020 earnings begin, we expect to see net interest margins under continued pressure at US banks. Although the Fed can force funding costs lower via QE, the impact on spreads for all types of bank assets is decidedly negative. This is why, dear friends, the yield on earning assets for all US banks is continuing to fall. Indeed, coupon spreads on MBS are at record all-time lows. But do you think anyone on the FOMC understands what this signifies?
Source: WGA LLC
So ask not, dear friends, whether Harker, Kaplan, Brainard or anyone else at the Fed have a clue about the direction of interest rates or markets. Ask instead whether all of the members of the FOMC will end QE and normalize interest rate policy before the central bank does serious damage to US banks and other investors, such as leveraged funds and REITs. And remember, when it comes to asset returns for banks, it's all about spreads, not benchmark interest rates.