Andrew Pyle
May 05, 2023
Is the bond market relief rally too late for relief?
Well, this has yet again been quite a week for the US banking sector. From last weekend’s arranged closure and purchase of First Republic by JP Morgan to Thursday’s announcement that TD had terminated its proposed $13 billion acquisition of First Horizon, this segment can’t seem to find stable footing. What looked like a calmer setting following the First Republic news, ended up being a return to volatility – all in a week where the Federal Reserve would decide on at least one more rate hike.
The uncertainty facing investors is compounded by the fact that short sellers are taking a “shoot first, ask questions later” approach, as regulators continue to deal with and untangle the developments that led to the first bank closure two months ago. Fundamentals have, however, shown improvement in recent weeks. The US banking system overall remains solid and many of the regional banks that had seen an exodus of deposits are starting to report increases in deposits through April.
This latter point becomes tricky as there is a difference between an actual gain in total deposits, versus an increase in the percentage of insured deposits (recall that the Federal Deposit Insurance Corporation, or FDIC, insures deposits up to a maximum of $250,000). In other words, if uninsured deposits leave, this will raise the percentage of insured deposits of the total. Even for those banks that have actually reported gains in absolute deposit levels, their shares have come under pressure.
The KBW Regional Banking Index consists of 50 of the largest US regional banks. After the sell-off on Thursday, it was down close to 35% since the start of the year and traded below 80 for the first time since November 2020. Note, this does not include those banks that have been closed or acquired. There is only one bank showing a gain on the year and that is New York Community Bancorp. The largest decline, at close to 80%, belongs to Pacwest Bancorp.
At this week’s FOMC meeting Q&A session, Chairman Powell was asked two key questions. First, was the market’s anticipation of rate cuts later in the year fair. Second, did he believe that this was an appropriate time to pause. While he again dismissed the first one on the basis that inflation had still not come to a level consistent with price stability and that (in his opinion) the economy was in better shape than what Federal Reserve staff economists predicted; he did indicate that rates were close to, if not already at restrictive enough levels.
Market participants are even more confident in the pause and remain of the opinion that economic activity is stalling at a faster pace than what the Chairman believes. The result of this is that bonds have resumed the rally that we enjoyed in March, with yields approaching the lows reached in early April. As the above chart shows, the 10yr US treasury yield is close to re-testing the 3.30% level and a break could see a move down to 3%.
This strength in bonds is not just coming from Mr. Powell. Stocks have stalled out since Monday’s advance and investors are once more looking for safety. Case in point, the S&P500 looked ready to breach 4200 on Monday – a level that had capped the upside back In February. Even though volatility has not spiked to the heights seen in March, the market has been jolted from the complacency of April.
Crude oil has also tumbled further in the first week this month and WTI futures hit an intraday low of $63.64 on Thursday – snapping the previous low of $64.12 on March 20th. This move, however, looks to be an anomaly with the sudden drop in Asian trading caused by either algorithm-based selling or what some have referred to as a “big thumb” (aka a trader hitting the wrong button). The market did rebound yesterday, but crude is still trading below $70 and investors see that as a clue that demand is weak.
Whatever the catalyst for a further decline in bond yields (meaning higher prices), this development can bring some relief to banks. Remember that much of the mess they are in now stemmed from some bad investment decisions by some. By loading up on longer-dated government bonds at the highs, they were extremely vulnerable to the eventual implosion in valuations as the Fed raised rates. Even in a recession scenario, Ally and I do not believe long-bond yields are going to return to the sub-1.5% levels of 2021. Yet, if yields could slip below 3%, this will lead to an improvement in balance sheets that, at the margin, should raise depositor confidence in the viability of a given bank.
There are a lot of moving parts for sure. For one, we still do not know how extensive the tightening in lending standards will be as banks struggle to shore up their balance sheets. While deposits in the financial system are still significantly higher than prior to the pandemic across the system, there will be areas of the U.S. where banks will be pulling back on lending and that could have a negative impact on economic activity.
On Monday (tentative), we will get the first quarter Senior Loan Officer Opinion Survey on bank lending practices (SLOOS). Discussion of credit conditions was prevalent throughout the post-FOMC Q&A with Powell and this suggests that the Fed already knows the results of the latest survey. Moreover, the Fed has likely seen a sizable tightening in conditions from the results, which would have entered into any decision to pause on future rate hikes.
In the fourth quarter, lending standards tightened for the sixth straight quarter and if market speculation is correct, the upcoming data could take standards close to the levels seen after the start of the pandemic. If so, then economists will probably bring forward their timing of a recession. True, that should reinforce a downward slide in bond yields. Until this translates into actual rate cuts by the Fed, I think the positive benefit for bank balance sheets, from improved bond valuations, will be offset by the impact on the income statement from weaker lending activity.
This morning, we have seen a rebound in bank stocks as buyers stepped in to snap up bargains created by the week’s tumble. We remain of the opinion that the majority of U.S. banks are trading below their intrinsic value, but the question going into the weekend will be how many more problem banks are still waiting to show up in the headlines.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle
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