What’s Going On
EU Banks were over levered going into the EU crisis. The ECB has forced them to delever and build up capital, even as they faced rising loan defaults and market headwinds. While most of the loan defaults are behind them, the banks’ plans to get to regulatory-mandated levels of capital makes assumptions of large increases in retained earnings.
Over the past year, a combination of QE and negative rates has flattened the yield curve substantially. The flattening has in turn resulted in substantial lower interest rate margins for the banks. In turn, this means lower expected earnings for the banks.
For the least profitable and weakest banks, this combination of low capital and lower future earnings has resulted in solvency concerns.
Since Deustche is a large bank, this very quickly turned into systemic concerns.
Systemic solvency concerns, as anyone who worked through the last recession knows, is everything.
Likely Effects in the Future
Weak Bank equity valuations will likely exert a drag on economic growth over time.
Generally speaking, banks need to increase or at least keep stable their net loan books.
Nominal GDP = Money Supply * Velocity
By keeping its loan book stable, banks can at least keep the Money Supply variable stable. That is one reason why historically it has been unusual to see NGDP grow with an extended period of contracting money supply.
When bank equity valuations are cheap, banks are incentivized to delever and buy back equity and / or debt, rather than make loans.
Here are some charts that show this. This shows the US bank index Price to book in white vs Commercial and Industrial Loans outstanding in Orange. Note how dips in value below 1.0 has historically preceded declines in C&I Loans outstanding.
This one is for Europe. Non-Financial Corporate Loans outstanding is in Orange.
The message from bank shareholders seems to be clear: stop the easing.
There is a big difference between liquidity concerns, solvency concerns, and profitability concerns. The order of importance is respective.
· At this point, liquidity concerns for senior unsecured debt is fairly minimal given ECB policy.
· Solvency concerns a bit higher, but is mitigated by lots of factors: a trigger on CoCo bonds would be supportive for solvency, and Germany and other EU countries in general are much better placed to inject capital. Yields are negative for them, after all!
· Profitability concerns are pretty big. The chart below shows the index price on top vs trailing 12m Earnings Per Share on the bottom. Despite the easy monetary conditions and the decrease in oil prices, EU banks have not really been able to sustain positive earnings over a 5 quarter period until recently:
Bank Solvency Concerns can take on a life of its own.
This shouldn’t be news to old market hands. The credit worthiness of a bank is to a large extent an article of faith by its creditors. Especially for large, opaque concerns like Deutsche, no one really knows the full extent of the risks. That is why solvency concerns can very quickly lead to a drying up of funding by creditors and an eventual liquidity crisis, which is what kills banks.
Having said that, given sufficient liquidity and time, these effects can stabilize. For banks that have sufficiently long and stable liquidity, they can buy back debt and/or equity. Even if RoE is zero, buying back debt below par and equity below book is accretive to earnings and valuation. But again, this is something that will take some time and/or action from policy makers.
I think credit spreads have also been getting impacted prior to this episode, but not in the way one’d think.
I’ve noted in the past that the Yield to Worst for investment grade credit has been broadly stable. However, there has been a sharp decline in treasury yields. The net effect is the credit spreads have widened by quite a bit. As the chart below illustrates, 30y credit spreads has hit levels not seen since mid 2009, even as the credit Yield to Worst has been stable:
Delving into the decline in treasury yields further, the decline has been mostly driven by the inflation compensation component. (in White below, with real yield in orange) Since the June highs in the nominal yield, the vast majority of the decline has been driven by the breakeven leg:
The interesting thing is that breakevens seem to have dropped even beyond levels implied by oil forwards: (not that 30y breakevens should be tracking oil price that closely anyway, but I digress)
A major additional factor is the policy rates overseas. The Fed has a measure of term premium for the 10y that has dropped sharply since the crisis. This term premium is strongly inversely correlated to the yield differential between US treasuries and global bonds elsewhere. The chart below illustrates: term premium is in white, and the US 10y yield differential between a basket of German, Japanese, and UK 10y yields is in orange and inverted.
Anyway, the point is that it seems like monetary policy overseas has also been a contributory factor to the pricing of treasury yields, which impacts US credit spreads, which in turns has implications across the capital stack, and a key driver of equity performance this year.
Credit spreads are so far having a limited impact on the economy, due to past bank deleveraging and regulatory prudence. This is supported by the recently released results from the Fed’s Senior Loan officer survey, which showed that despite the sharp widening in corporate credit spreads, only a small percentage of banks tightened credit to corporate borrowers on net, roughly unchanged from 3Q. Obviously, we shouldn’t expect this divergence to persist forever, but it does suggest that the new regulatory policies has been successful in insulating banks from market volatility somewhat.
The goal of QE is to decrease yield, lift risk assets and weaken the currency.
Since 3m OIS swaps have declined below -10bps and 0bps in Europe and Japan respectively, exactly the opposite has happened. In Europe, since 3m OIS swaps (orange) declined below 10bpsin early April, the EUR (white) is higher vs the dollar, bank shares (purple) has gotten annihilated, and even the average of 30y EUR sovereign bond yields, (yellow) the asset the ECB is buying directly, is higher in yield.
The story is the same in Japan. Since the BoJ cut, the Yen (white) is 6 figures stronger vs the dollar, the Topix bank index (yellow) is 20% lower, and even 30y JGB yields (green) are higher post cut!
My hope is that the ECB and BoJ have started to recognize these issues, and are beginning to consider ways to mitigate them. At the very least, the pace of deterioration in bank shares the past few weeks will have gotten their attention. A bit of stability in oil prices should also help inflation stabilize and reduce the desire for further easing.
A pullback by these central banks from further easing will help both bank prices as well as treasury yields rise. This in turn is likely to be supportive (or less unsupportive) for lending, while the higher Treasury yields allow the EUR and JPY to weaken. Paradoxically, a shift away from dovishness by those central banks is likely to be risk positive. Because as many of us have intuitively understood, negative rates are not stimulative on net.