Dec 16. Banks and Central Banks

On Dec 10, Urjit Patel abruptly resigned as the head of the RBI (India’s Central Bank).  From the Economist, “Mr Patel’s resignation,and what it says about the government’s attitude towards institutions, is something ‘all Indians should be concerned about’ said [Raghuram] Rajan.”  Rajan was Patel’s highly respected predecessor.  It’s not something that just India should be concerned about.  It’s something that Americans and all spectators of central bank independence should be concerned about.  Modi’s government is intent on juicing up the economy through lax central bank policies, which ultimately led to Patel’s departure.  In fact, Patel was the first EM central banker to publicly plead with the Federal Reserve to end balance sheet reduction. On June 4, Patel wrote in the FT, “Given the rapid rise in the size of the US deficit, the Fed must respond by slowing plans to shrink its balance sheet.  If it does not, Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond market is inevitable.”  Well here we are six months later.  Patel is out, but his words echo eerily prescient.  If the Fed doesn’t slow its path, “…the possibility will increase for a sudden stop for the global economic recovery.” 

The Fed at this week’s meeting is widely expected to raise the FF target, with an increase in IEOR of just 20bps.  I expect hints of a slowdown in the Fed’s balance sheet reduction program. In any case, Trump will certainly tweet his displeasure with Powell as he has the same incentive to boost the economy as Modi. The Fed’s independence could become a more important topic over the coming year.  

On Friday near the end of the session.I bought shares of Citibank (looking for a relatively quick flip THIS IS NOT A RECOMMENDATION). The financial sector has taken a good thumping this year, with many Systemically Important names closing at new ytd lows this week.  The financial etf, XLF, is down about 18.5%to a new low for the year on Friday.  As the table below shows, some names have suffered much larger declines.  What I have done in the table is roughly note the percentage declines in the banks this year (many had their highs set in Q1)and then compare that to the period of mid-2015 to early 2016.  Recall that the market and the Fed were leaning heavily for a hike in September ‘15, but because of a slide in oil and other commodities, and corresponding turmoil in Emerging Markets, the Fed did NOT hike in autumn, but did move in December. At that time, the large US equity indices were selling off.  Junk spreads were blowing out, due primarily to stress in the energy sector.  In other words, some of the conditions were similar to current events.  Of course, by Q1 2016, US stocks had bottomed, and commenced a solid 24 month run-up, even though the Fed was in a ‘tightening’ mode (the second hike was in December 2016).  So it’s reasonable to compare these two periods in an effort to determine how much the current weakness might have to run.  One thing to note early on is that the present slide in WTI Crude from around 77 to 51 or 33% in a little over two months, is dramatic, but in mid-2014 the front contract was  108 and it fell all the way to 25 by Q1 2016(when stocks also bottomed).  So that sell-off was over 75%.   

I am focusing mostly on the banks because I think we’re in for a dovish hike and the prospect that balance sheet reduction could be slowed significantly. As a sector, financials are now about 13.7% of the SPX.  If the banks remain weighed down, it’s going to be pretty difficult to get a general rally.

GLOBAL SIB/US 2018 high to low % 2015 hi to ’16 low
Bank of American BAC 26 40
BONY BK 16 28
Citibank C 31 43
Goldman GS 37 36
JPM Chase JPM 16 23
Morgan Stanley MS 33 48
State Street STT 45 37
Wells Fargo WFC 19 24
Financial ETF XLF 19 20

From this rudimentary table one could surmise that there’s a bit more selling to come.  In terms of a broader picture, in 2015 to early 2016 the decline in SPX was about 15%. In February’s VIX blow-up, SPX had a pull back of a bit over 11% and the current decline has also been a little over 11%, from 2940 to 2600. 

While SPX closed on the low of theday/week, VIX fell week over week (possible bullish divergence).  Below I am also including a list of domestically important banks.  The decline in leveraged loans, the decline in credit quality and corresponding increase in corporate spreads, and the flatness of the curve are all conspiring to present challenges to the financial sector. Of the 19 stocks, 15 are down 20% or more.

DOMESTIC (not all inclusive)2018 high to low %
AllyALLY25% new low
American ExpressAXPhas rallied 
BBTBBT18% new low
Bank of Montreal BMO20% new low
Capital OneCOF26% new low
ComericaCMA32% new low
DiscoverDFS24% new low
5th ThirdFITB20% new low
Huntington BancsharesHBAN26% new low
Key CorpKEY32% new low
M&T BankMTB25% new low
Northern TrustNTRS22% new low
PNCPNC27%
CitizensCFG37% new low
RegionsRF32% new low
Santandar USASC17%
SunTrustSTI30% new low
US BancorpUSB16% new low
ZionsZION30% new low

These charts are ugly.  And the banking stocks in Europe are just as bad.  The question is whether there’s a lot more to come. Despite the decline in stocks, yields closed a bit higher on the week. Will the Fed bend to stresses in financial markets and signal easier policy to come?  The Eurodollar curve is certainly pushing for that scenario.  The one year spread between EDH19 and EDH20 closed POSITIVE 8.5 bps, but six months forward the EDU19/EDU20 spread settled MINUS 8.5: same magnitude, different sign.  Within six months the market forecasts a possible hike to a possible ease.  It’s rather extraordinary. 

In a world where new forms of energy are being developed, is it still only about oil?  I looked at a constant maturity chart of what will now be the first three-month Eurodollar calendar spread, March’19 to June’19.  It reminded me of the WTI chart so I put them together (below).   Fairly strong relationship.  There’s no question that the implosion of oil and the commodity index has sucked market measures of inflation into the vortex of the toilet, and with it, expectations for forward hikes.  There’s one other thing to note,and that’s this: the highs in both oil and the calendar spread occurred in early October.  SPX also peaked in early October.  On October 2, journalist Jamal Khashoggi was killed, and on October 3, Powell made his now famous, “…we’re a long way from neutral” comment.  TheMacroTourist (link below) shows that real yields accelerated higher in the wake of that comment, spreads widened, stocks broke. It might have been the last straw relating to Patel’s omen of a dollar liquidity crisis.  Colleague LM mentioned that the Saudis probably flooded the market with oil to put the Khashoggi episode behind them.  In any case, the beginning of October was an inflection point.  

The Fed already has walked back the harsh rhetoric, and will likely seek to smooth roiled markets at Wednesday’s press conference.  Here’s the problem:  After the 2nd hike in Dec 2016,the five year treasury was around 1.90%. It’s now 2.73%.  The BBB-Corporate spread was 160, it’s now 190.  Rates that companies pay to roll over the debt they’ve gorged on are going to be higher.  A JPM report suggests “the downgrade and fallen angel risks look pretty elevated at the moment for both US and European high grade corporates, raising the prospect of disorderly transfer of risk between HG and HY markets over the coming year.”  Using bank stocks as a proxy for the generosity of financial markets in terms of accommodation, the welcome mat has been yanked.  The Fed has to be sensitive to that, while at the same time not appearing to have completely caved in to Trump.  I expect both stocks and fixed income to rally coming out of the FOMC (if not before), with the red pack (2nd year) being the strongest part of the Eurodollar strip, i.e. I expect red/green and red/blue pack spreads to strengthen from their currently negative levels,and perhaps even go positive.

Other events which may impact the week are President Xi’s major speech on Tuesday to mark the 40thanniversary of China’s reforms, and the possibility of Mueller/Trump bombshells.  In terms of China, the news has been mostly bad, with many negative articles in the financial press.  So far, gov’t stimulus measures haven’t helped housing and autos, but Xi may indicate more powerful forces to come.

Posted on December 16, 2018 at 1:13 pm by alexmanzara · Permalink
In: Eurodollar Options

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