The guest commentary below was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst.
Fed Chairman Jerome Powell confirmed this week that the FOMC is unlikely to make any further reductions in interest rates for the balance of 2019.
Various market observers have offered opinions about whether the interest rate environment is good for banks and those with leverage or not. Suffice to say that the spreads between rates in dollars and different currencies – specifically euro and yen -- are more important than the notional "neutral rate” of interest in dollars that fills the imaginings of many economists.
In that regard, we have posted a new assessment for Citigroup Inc. (C) in The IRA online store. Like the other members of the Bank Dead Pool, our view of the quantitative and qualitative factors affecting C is decidedly negative. Poor asset returns, expensive funding, geographic diversity in all of the wrong places, limited liquidity and the world’s biggest derivatives book somehow just doesn’t do it for us.
To paraphrase Jim Grant’s observation about Fed Chairman Powell, Citigroup CEO Michael Corbat is a prisoner of history. With Citi's battered currency trading barely at par, there is nobody among large banks with stable, core deposit liquidity out there for sale at a price that Citi can pay. We write in the most recent assessment:
“Unless and until the management team led by Michael Corbat finds a way to enhance the bank’s financial performance and/or funding, we expect the bank to continue to underperform its asset peers in terms of market valuations. We believe that a change in the operational path of C is unlikely to occur in the near term and is only likely to occur at all as and when regulators compel a combination with another large bank.”
We compare Citigroup with JPMorgan Chase (JPM), U.S. Bancorp (USB), American Express Company (AXP), Capital One Financial (COF) and the 125 largest US banks in Peer Group 1. Suffice to say that the head-to-head with AXP, which is the best performing large bank in the US and trades over 4x book value, isn’t too pretty. Even though the smaller AXP has a higher cost of funds than C, it delivers far better asset and equity returns than the $1.9 trillion zombie bank.
In other news around the financial markets, Chairman Powell appeared on Capitol Hill this week and confirmed that the FOMC has fixed the liquidity problem in the repo market, at least for now. It is no accident that the VIX and other measures of volatility have basically collapsed since the FOMC opened the monetary spigot back in September. The correlation between adverse changes in the financial market stress and the subsequent launch of a new QE program has been widely remarked, but not it seems inside the FOMC.
It is pretty clear that the markets globally cannot tolerate any meaningful decrease in the Fed’s balance sheet without the short-term credit markets seizing up. From the end of 2017 to July of 2019, the Fed’s System Open Market Account (SOMA) shrank by just over $400 billion or 10% of the Fed’s total assets. Yet the impact on the financial markets was dire indeed, as shown in the chart below.
Notice that liquidity related stress due to QT pushed the VIX to 35 last December. Then seasonal factors lulled us all back to sleep, even as the contraction of the SOMA continued. Over the summer, however, idiosyncratic factors combined with ebbing liquidity to cause an increase in visible volatility. The quarter-end in June, however, saw significant problems in repo land.
By August, the increased perturbations in the VIX, to borrow a favorite term of our colleague Dennis Santiago, then caused the equity markets to become unstable. When the word “repo” started to appear in headlines on CNBC and in The Wall Street Journal, that signaled a change in the direction of Fed policy.
When President Donald Trump gives Powell a hard time about interest rates, the Fed Chairman need only point to the VIX and the S&P 500 for the proof of the efficacy of monetary policy. But the more important point to make is that the US central bank now is in the position of defending both the bond and equity markets (and, indirectly, the dollar) by maintaining minimum levels of liquidity in the credit markets.
So how does this impact banks? The good news is that the rate of increase in bank funding costs slowed after Q2 2019. Also, banks have made some progress in the past several years in getting some increase in loan spreads, but the competition for assets at all levels of the banking industry effectively caps the asset return upside.
If you take the five-year Treasury less Fed funds as a surrogate for net bank loan spreads, the spread was negative from March through September, when the easing and liquidity operations of the FOMC widened spreads dramatically. But the FF-to-5s spread only just crossed back into positive territory in late October.
The good news is that the direction of monetary policy or at least liquidity policy, seems to support a gradual widening of spreads. After two years of tightening during the Fed’s ill-considered balance sheet contraction, the message of the markets is that an inverted yield curve is bad.
As the imperative of the Fed has shifted from stoking inflation to maintaining liquidity, the ability to tighten monetary policy at all has been lost. The public narrative from the FOMC is still a tangled confusion of econometric bullshit that has no relationship to the Fed's actions in the marketplace. The practical task facing the Fed is to defend the all-important liquidity vs VIX relationship. So long as volatility remains muted, monetary policy will remain in neutral. But when volatility starts to climb, look for more liquidity measures from the Powell FOMC.
EDITOR'S NOTE
This Hedgeye Guest Contributor piece was written by Christopher Whalen, author of the book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. This piece does not necessarily reflect the opinion of Hedgeye.
