Bank stocks’ problem isn’t just rates

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Good morning. Among big cap US stocks yesterday, some of the largest losers were snack and sweet drinks giants such as Mondelez, Coca-Cola, Pepsi and Kraft-Heinz. Part of the reason may have been a soft earnings report from ConAgra, the packaged food company. The chief executive said consumers were stretched and cutting back on spending. Another, more intriguing factor: the chief executive of Walmart said that new injectable diet drugs were having a small but noticeable negative impact on grocery purchases. If you have the long pharma/short junk food pair trade on, email us: [email protected] and [email protected]. 

Banks

Third-quarter earnings season starts in earnest next week, when the big banks start to report. Expectations for the group appear to be low and falling. In the past week, bank indices have underperformed the wider market by a couple percentage points, and certain banks’ shares look downright sickly. 

What is going on? One candidate explanation is that long-term interest rates have been rising, which means that banks’ securities portfolios will have to be marked down again. Because most of these securities are accounted for as hold to maturity (HTM), this will not directly affect capital or earnings. But HTM losses are disclosed, and they make people a little jumpy when combined with other risk factors. Several banks discovered this, fatally, in the mini bank crisis back in March. Goldman Sachs estimates that securities losses grew from $525bn to $683bn over the course of the third quarter. Hypothetically, if (let me say again: if) these losses were taken out of capital, it would move the industry’s tier one equity ratio from 10.9 per cent to 7.4 per cent. That’s a lot.

This explanation makes sense of the fact that one of the banks that has performed the worst lately is Bank of America, which has an immense long-dated security portfolio. But it is an unsatisfactory explanation for other reasons. One is that the industry exposure to long-term interest rates is extremely well known, and those rates have been rising steadily since the end of August. Why did the penny drop only in recent days?

Furthermore, these well-telegraphed securities losses seem unlikely to matter much. The losses at Silicon Valley Bank and First Republic mattered only because the banks also had low margins and loads of uninsured deposits, and ran into liquidity crises. Bank of America has liquidity coming out of its ears. And if a bank does need liquidity, the Fed’s Bank Term Funding Program, established as a safety valve in March, is still open.  

A somewhat more compelling explanation is that banks’ third-quarter earnings reports are not going to be very good. Margins are going to fall. On the liability side of banks’ balance sheets, deposit costs are rising. On the asset side, loan growth has been falling steadily all year:

But why is loan growth weakening? Part of the story, although it is not clear how much, is that large banks are on a balance sheet diet because capital requirements are set to rise over the next few years, as part of the so-called Basel III endgame. The banks need to cut weight to keep their return on equity up. My colleague Josh Franklin reported this week that JPMorgan Chase, for example, was planning to pick up the pace at which it securitises and sells off consumer loans in advance of the rule changes. 

A more alarming possibility, however, is that loan growth is falling because of weak loan demand — which is, after all, the intended effect of higher interest rate policy. Fewer investment projects make sense when money costs 8 per cent than when it costs 3 per cent, so fewer projects get done, and less money gets borrowed. 

This point is related to a final explanation — to my mind, the most compelling one — for bank stocks’ limp performance. No one wants to own banks if we are heading into a recession, and recession fears are creeping back into markets again. This theory fits nicely with the weakness in cyclical stocks we wrote about earlier this week. Higher rates, tighter margins, more punitive regulations: we saw all these things coming. What has changed quite suddenly is investors’ risk appetites. 

The rising term premium 

On Monday, Unhedged dwelled briefly on a remarkable change in the Treasury market: the term premium on 10-year Treasuries appears to have turned positive again. The term premium, you’ll recall, is the difference in yield between, say, a 10-year Treasury and a 1-year Treasury rolled over 10 times. It is compensation for the interest rate risk intrinsic to longer-dated bonds. The term premium is unobservable, so it’s measured using models. But the two most-used models indicate that the premium is up a lot recently. Notably, this is the first time since 2017 that both models have shown a positive premium:

This trend, if sustained, could drive the soaring 10-year yield still higher, possibly denting stocks and the economy in the process. That’s a big “if”, of course, so it matters why the term premium is rising. Here are the possible explanations we could come up with:

• Expected rate volatility is higher.

• Expected inflation volatility is higher.

• Uncertainty around US solvency and/or political stability is higher.

• Treasury supply is set to rise sharply.

• On the margin, Treasury demand is growing more price-sensitive, forcing higher yields.

• Reach-for-yield dynamics, which nudged investors away from shorter-term bonds, have ebbed, so longer-dated Treasuries need to offer greater coupons.

• The four-decade bond bull market is widely believed to be over, so investors want more coupon in place of the expectation of capital appreciation.

We’ll discuss each of these in greater detail next week, but if there are any possibilities we’ve left out, we’d be grateful to hear about it on email. (Ethan Wu)

One good read

More detail on the American nightmare.