Treasuries once again experienced what amounts to a sharp curve flattening in recent days. The market action resembled what took place after the initial announcement of taper back in December (see post). The yields in the “belly” of the curve have risen sharply as the market prepares for rate “normalization”.
The treasury yield curve remains quite steep by historical standards. Typically such steepness is driven by expectations of higher inflation in the future. But as discussed earlier, that is not the case in the US (see post). Instead it is the expectati…
Since the Fed announced the reduction in securities purchases (“small taper”), the treasury curve has undergone some strange adjustments. Here is what the impact has been since the close on December 17th. Why would the 5-year note sell off the most whi…
The US banking sector continues to outperform the broader market. Furthermore, for the first time this year, regional bank shares are outperforming the overall bank index, which is driven primarily by the largest banks.
|Red = S&P500; Green = S&P total banking sector index ETF; Blue = S&P regional banks index ETF|
The key reason for the strong performance among US banks remains the steepening treasury curve. Banks pay next to nothing on deposits while charging a rate that is often linked to treasuries on the loans they make. The steeper the curve, the wider the “margin”. And given the leverage inherent in the banking system, even a small margin increase materially improves the return on equity.
The treasury curve has been steepening sharply in recent weeks – as seen from the spread between the 10y and the 2y yields (as well as 30y and 2y).
What’s driving this steepening? Historically, rising longer dated bond yields were caused by higher inflation expectations. That’s not the case this time around. In fact as the chart below shows, longer-term inflation expectations have been declining.
|Dow Jones Credit Suisse 10-Year Inflation Breakeven Index|
The rise in yields is instead mostly driven by higher expectations of earlier and faster reductions in securities purchases by the Fed. In particular, some at the Fed have been happy to see a bit of stabilization in monthly payrolls growth (at around 200K).
The sustainability of this trend is yet to be proven, but combined with better GDP figures (see chart) and improved new home sales (see chart), these data may be sufficient to push even this dovish FOMC into launching its exit sooner than expected. The fact that corporate spreads are at the levels not seen since 2007 (see post) doesn’t help the case for maintaining the current pace of QE either.
At the same time, Bernanke was quite clear that it will be some time before the Fed will begin pushing up short-term rates – even after QE ends. We therefore have the short-term rates (and therefore bank deposit rates) remaining near zero, while longer term rates rising due to expectations of taper. This is resulting in significant curve steepening, a great environment for banks.
The next question is why all of a sudden we are seeing regional banks outperforming the overall banking sector. The answer has to do with the changing regulatory landscape, as the Volcker Rule is about to go into effect.
WSJ: – Barring a last-minute surprise, the votes will result in tighter restrictions on certain trading activities that go beyond what regulators had agreed to just a few weeks ago, according to people familiar with the matter. Since then, regulators have been locked in tense negotiations that threatened to upend the provision.
Under the final rule, regulators are expected to closely track trading activities with an eye on whether certain trades known as hedges are designed to post a profit rather than offset risks that accompany trading with clients. The finished version of the Volcker rule is likely to require that hedges be designed to reduce specific risks, according to a portion of the proposed rule reviewed by The Wall Street Journal.
Hedging activity should shrink or alleviate “one or more specific, identifiable risks” such as market risk, currency or foreign-exchange risk, and interest-rate risk, the language says.
“This is the new era of Big Brother banking,” said Michael Mayo, an analyst with CLSA Americas. “Now banks’ fortunes are more closely tied to the government.”
This “Big Brother banking” will have a far greater effect on the largest financial institutions than on the regional or smaller banks. The inability to trade in “prop” accounts is already resulting in reduced liquidity and weaker market making capability among the larger banks. As a result, in the US bond markets for example, banks often do little more than act as “introduction brokers” for a quarter-point spread. In some instances this is far cry from the high volume market-making activities banks used to be involved in. All this is resulting in declining “sales & trading” revenue for the largest banks.
Bloomberg: – The $44 billion at stake represents principal trading revenue at the five largest Wall Street firms in the 12 months ended Sept. 30, led by New York-based JPMorgan, the biggest U.S. lender, with $11.4 billion. An additional $14 billion of the banks’ investment revenue could be reduced by the rule’s limits on stakes in hedge funds and private-equity deals. Collectively, the sum represents 18 percent of the companies’ revenue.
Not facing these same headwinds, regional banks are now outperforming.
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The FOMC announcement to hold the status quo on securities purchases resulted in a flatter yield curve.While this surprising decision by the Fed helped a number of “risk-on” assets, it was a negative for banks. Bank shares rallied initially with equity…
Since the beginning of the year the US treasury curve has steepened substantially, with yields on the short-end actually declining.There are two key reasons for treasury bill rates staying at such suppressed levels.1. In a rising rate environment, dura…
US equity markets are continuing to price in higher premiums for bank shares relative to the overall market. The increased steepness of the yield curve will mean higher net interest income, as banks borrow at historically low rates from depositors and …
The treasury curve has steepened materially over the past few weeks, driven by Bernanke’s seemingly hawkish statements. One group of companies that will benefit from this adjustment is the banking sector.
In fact bank shares have been outperforming the broader market by a significant margin – over 6% in the past couple of months.
The reason is simple. Given the short end of the curve has not budged, banks will continue to pay next to nothing on deposits. But they can now charge much higher rates on new term loans they make. That spread increase (net interest income) will flow right into equity and juice up bank dividends. Bank shareholders and executives should thank Bernanke for this “gift”.
But there are headwinds appearing on the horizon for the banking sector that may negate some of these gains. Here are a few examples:
1. A portion of bank revenue has been generated from mortgage refinancing in the past couple of years. But that game is over (see post) and the refi fee revenue will no longer be there. We’ll let our friends who analyze bank shares quantify that number, but it can’t be immaterial.
2. With rates rising, loan demand in the corporate sector may in fact decline. We are already seeing evidence of that.
On top of reducing origination fees and asset growth for banks, this trend could easily result in slower economic growth, which has been quite fragile to begin with.
3. Treasury and agency securities make up about 10% of bank assets. Even though not all of these securities will get marked to market, the recent bond correction can’t be good for the old P&L. Customer flows in fixed income departments of banks will also decline materially.
4. New regulatory pressures could create tremendous headwinds for the larger banks and could even result in dividends being shut off for years to come as banks are forced to build up capital.
Bloomberg: – U.S. regulators are considering doubling a minimum capital requirement for the largest banks, which could force some of them to halt dividend payments.
The standard would increase the amount of capital the lenders must hold to 6 percent of total assets, regardless of their risk, according to four people with knowledge of the talks. That’s twice the level set by global banking supervisors.
For those who think banks haven’t been lending enough, just wait till such rules go into effect. We will see an outright credit contraction in the US.
Given these headwinds in the banking sector, one should be careful jumping on the bank shares bandwagon. There may be some nasty earnings surprises along the way. And with banks under pressure, those who are predicting the US GDP to grow at 2.5% or higher should go back to the drawing board.
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