More of the same, or something new?

Thursday 11th February 2016

More of the same, or something new?

ref :- "Profits to be made from bank's bear scare  --  but not yet" , John Authers in the Financial Times, p.32 and online

When you've been away for a while, trying as much as possible NOT to follow things too closely  (that's just irresponsible, surely?), it's kind of crucial to get an immediate handle on things on your return. What are the markets doing and why  --  in short, what's changed ?

At first glance one could be forgiven for thinking the answer to that would be "not too much", and that's not good : tumbling equity markets and oil prices, safe-haven buying of government bonds, gold, Jap Yen and Euros  --  all this looks very familiar, right ? So is this just a case of everything being locked into the same dark spiral that we've seen since the start of the year ?

Well, yes and no ..... if the same worries over the wider macroeconomic issues remain firmly in place, the more specific focuses of attention have shifted somewhat (should that be foci?). And if it was concern over Chinese growth and oil prices that prompted the sell-off from the start of the year, it's a run on bank shares and bonds that hold centre stage right now. Unsurprisingly however, and as Mr Authers points out, there's a link .... there's always a link, and essentially we're talking about the course of global interest rates and the ability, or rather the inability, of central banks to manage both rates and inflation.

In the light of recent events, the cautious (doveish?) nature of US Fed Chair Janet Yellen's comments yesterday hardly came as any surprise. She declined to show any regret over December's rate rise but not too much should be read into that and decisions on future hikes will remain data-dependent , which just now would seem to suggest that they're unlikely to come in any great hurry. Remember, at the December meeting of the Fed's Open Market Committee the consensus view among its members was that we would see four, 25bp rises in 2016. Futures markets now point to a 30% chance of any rate hikes this year. The truth may lie somewhere between the two but the odds would now seem to suggest that things will pan out closer to the market's view that the Fed's. Which in turn suggests that the Fed is not really in control and is unlikely to have to deal with any desirable upmoves in inflation.

The belief that the monetary tightening process may already be largely completed intensifies deflationary pressures, and encourages buying in the longer end of the bond market. Remembering that as prices go up, yields come down, this of course FLATTENS the yield-curve  --  the extra yield available on long-term bonds over short-term bonds. At the time of writing the premium of the yield of a 10yr Treasury Note over its 2yr equivalent is threatening to break below 1%, making the curve flatter than it's been for nine years and flatter even than the crisis year of 2008.

Flat yield curves like this often presage recession, which would of course be bad news for everyone. But by definition, they're particularly bad news for banks. At the most simple but equally most important level, banks make money by borrowing short-term money at cheaper levels and lending longer-term money at higher ones, and the steeper the yield curve the more profitable the process is. Central bank efforts to encourage a little inflation that might boost yields at the longer end have plainly failed up to now and it's having a pretty unhealthy effect on forecasts for banks' profitability.

And then there's negative rates, and in particular the Bank of Japan's recent decision to "go negative". If it was meant as signal that the BoJ would do whatever it takes to weaken the Yen (and thus encourage inflationary pressure), it has failed fairly comprehensively. Safe-haven buying has seen an ever-stronger Yen despite the move. Which begs the question ..... how negative would rates have to be before they significantly affected the exchange rate ?  Pretty low it seems, and whilst economies have handled below-zero rate scenarios much better than some feared up to now, they're no good for banks. They can't pass on all the costs to their depositors without losing a proportion of them, and they can't continue to absorb costs without damaging their own balance sheets.

So there is logic to financial stocks being under the cosh ..... but for how long ? Mr Authors argues that banks generally and particularly in the US are in a much healthier position balance sheet-wise than they have been in the past. Certainly they have reserves at their disposal than makes some of the recent downmoves look excessive ..... well, who could be surprised at the market overreacting ? The suggestion is that whilst the bloodletting may not be over yet,  sooner or later these banks are going to look cheap.