This note was originally published at 8am on September 22, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“We can never be gods, after all--but we can become something less than human with frightening ease.”
-N.K. Jemisin, “The Hundred Thousand Kingdoms”
I think we can all be thankful for one thing this morning: we no longer have to talk or joke about “The Twist”. The current Federal Reserve Board once again proved their incompetence as it relates to managing the monetary affairs of the nation. Not only did the stock market not twist, or torque (as Morgan Stanley so calls it), it tanked.
Yesterday actually harkens back to the heady days of 2008 when former Secretary of the Treasury, Hank “The Market Tank” Paulson, would get on T.V. to ostensibly calm the markets and inadvertently talk the Dow down a few hundred handles.
We’ve said it once, and we’ll say it again, the best action that the Federal Reserve can take is to stop what they are doing. QE 1 was ineffective, QE 2 was ineffective, and QE 2.5 Twistaroo will not work either.
As The Economist wrote back in March 2011:
“Operation Twist has long been considered a failure. Early studies found little impact on yields, vindicating those who argued that the price of a security depends only on expectations—of inflation, for example, or monetary policy—not its relative supply.”
Not only did QE1 and QE2 not work, but The Twist itself was tried before in 1961 and deemed a failure.
In case you missed the Fed’s announcement yesterday, or have just decided to tune the Fed out, I’ll explain their intention. The plan is for the Federal Reserve to buy $400 billion of bonds with maturities of six to 30 years, while at the same time selling an equal amount of debt maturing in three years or less. These actions will occur between now and next June.
Ostensibly, the intention of such an action would be to narrow the yield curve and bring down long term interest rates. Undoubtedly the Fed Heads are hoping this will lead to a rash of mortgage refinancing, which will free up cash for consumers to spend. This idea is cool in the theories of macroeconomic textbooks. . . unfortunately real life is not theoretical. This action actually has very negative implications for an already tenuous global banking sector.
Simply, a narrowing of the yield curve hurts financial stocks. The cash flow of financial companies is driven by a funny little critter called net interest margin, or NIM. Banks borrow short and lend long, and thus collect a spread on the transaction. As the yield curve naturally narrows, or forcefully narrows by Keynesian intervention, the margins for banks compress.
Our Financials Team, led by Josh Steiner, actually discussed this very topic a few weeks via a 65+ page in-depth study on the topic (ping firstname.lastname@example.org if you’d like to trial our Financials vertical and receive access to the deck and Steiner’s team for dialogue). In the Chart(s) of the Day today, we borrowed two charts from Steiner’s presentation. The first chart shows that asset yields for the major banks, Bank of America, JP Morgan, Citigroup, and Wells Fargo specifically, track the 10-year yield with a very high correlation. So, as 10-year yields decline, so too do asset yields for major banks. In the second chart we show the potential impact on margins. In short, as we think 2012 earnings estimates for the major banks could get cut in half.
The credit default swap markets for the major banks reacted as we expected yesterday and widened dramatically. Specifically:
- Bank of America 5-year CDS widened 11.7% to 372 basis points;
- Wells Fargo 5-year CDS widened by 12.6% to 142 basis points;
- Citigroup 5-year CDS widened by 12.5% to 260 basis points;
- Morgan Stanley 5-year CDS widened by 12.0% to 355 basis points;
- JP Morgan 5-year CDS widened by 10.6% to 146 basis points.
It’s worth mentioning that Moody’s came out and downgraded the long-term credit ratings of Bank of America and Wells Fargo, citing, “an increased likelihood that the federal government allows a large U.S. bank to collapse.” We’re not so sure how much, if at all, impact this had on the credit markets, given that: a) ratings agencies are lagging indicators and b) the results of allowing a “large U.S. bank to collapse” didn’t go so well the last time (Lehman Bros.).
As indicated by the moves in the CDS markets, the irony is that the Fed’s actions yesterday negatively impacted the creditworthiness of major banks and, no doubt, their willingness to more aggressively extend loans and credit.
For those of you that aren’t applying for Canadian passports after the Fed’s actions yesterday, we are hosting call at 11am eastern today titled, “What’s Next for the Eurozone?” Akin to the idea of being the tallest dwarf, the intermediate term future looks increasingly negative for Europe, which on a relative basis actually makes the U.S, in particular the U.S. dollar, look good.
On the call today we are going to spend time going through the history of the European Monetary Union, discuss the lead up to the beginning of the sovereign debt crises, as well as potential outcomes. A key focus on the call will be on the exposures of the European banking sector to PIIGish sovereign debt. In some instances, these exposures make subprime look like a speed bump.
We will be sending the presentation and dial in materials for the call to our clients later this morning, but if you are not a client and would like to trial our institutional service then please email our head of sales, Jen Kane, at email@example.com. Jen recently returned from maternity leave and would love to chat with you.
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research