Deutsche Bank: A Curious Case Of Mistaken Identity

| About: Deutsche Bank (DB)

I like to keep an eye on major financials, as they are the backbone of the global economy. If the banks have problems, not much else will be doing all that great from a macro perspective. I know there are serious issues with European financials as collapsing (and in some cases negative) government bond yields, coupled with negative short-term policy rates, have basically shrunk their net interest margins as their loans are priced off those rates. The same is the case in Japan. In the U.S, despite massive flattening of the Treasury yield curve, we have so far been spared from this rather unfortunate banking situation.

So I punched out the ticker “DB” on my screen last Friday and looked at the TV before the chart would load. I looked back at the screen and I thought I had made a mistake as sometimes the web browser will “remember” ticker symbols on the drop-down quote menu and occasionally the wrong chart would load.

It had to be a mistake, as I was looking at the 10-year Treasury yield chart that was just shown on the TV screen seconds earlier, with some futures trader making the comment that the U.S. Treasury market was “breaking out.” I looked closer and I was stunned. There was no mistake. To that moment, I had not realized that Deutsche Bank’s stock was tracking the 10-year Treasury note yield almost tit for tat.

If the Treasury market is breaking out, that would mean Deutsche Bank stock is breaking down, I thought.

Deutsche Bank Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

It did not take long to figure out why the stock of a major global financial firm – DB, the largest bank in Germany – would follow the 10-year U.S. Treasury yield so closely. As I have explained on numerous occasions in this column, I think we face a global deflationary problem.

There are numerous implications for this, but economic growth cycles driven by too much borrowing in the developed world and in many emerging markets – the largest of which is China – are causing that mountain of debt to catch up with faltering economies. Falling long-term U.S. interest rates at a time when the Federal Reserve has not officially given up on a hopelessly-misguided rate-hiking cycle are a symptom of this global deflation.

Banks tend to perform very poorly in a deflationary environment as weak nominal corporate revenues make servicing debts problematic and lending growth tends to suffer. In a deflationary environment, the real value of debts rises as they stay nominally constant; but the assets those debts are financing tend to fall in price, causing rising NPL ratios. Combine this with the unorthodox global QE monetary policies and negative short-term interest rates and you have collapsing net interest margins for many global banks like Deutsche Bank as many yield curves globally, including the one in Germany, have vanished.

Germany Ten Year Government Bond Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The German 10-year bund yield – the equivalent of our 10-year U.S. Treasury yield – hit just three basis points (0.03%) last week, an all-time low. The German 2-year Schatz yield, the equivalent of our 2-year Treasury, hit negative 53 basis points (-0.53%). I guess you can call that a positive yield curve, since you must subtract a negative number from the miniscule positive yield (3-(-53) = +56 bps). While this simple mathematical equation may be technically correct, practically it is causing serious issues for Deutsche Bank and all European financials.

Since loans are priced off risk-free rates (i.e. the 2-year Schatz and the 10-year bund yields), those loans have tiny interest rates. Also, while corporate lending so far is still being done at positive interest rates, the collapse in the German yield curve is also collapsing DB’s net interest margins and profitability. (When it comes to the German market, Deutsche Bank is global in nature.)

Fed Ten Year Constant Maturity Rate Bond Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

In the U.S., at least we have a positive yield curve. Yes, it is massively flattening as it hit another multi-year low at 91 basis points last week; but at least we are not yet dealing with Germany’s financial system absurdity, deducting negative numbers from a barely positive number to get to a positive yield curve!

I don’t mean to pick on Deutsche Bank, but it does help illustrate the state of affairs in the global financial system. When a major global financial stock is trading at 29 cents per book value dollar (0.29 P/B), then something is wrong.

Deutsche Bank - Monthly OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

At 29% of book value, Deutsche Bank stock is symptomatic of a problem that has not yet surfaced, in my opinion. The stock is below the 2008/2009 Great Financial Crisis low and it is not the only European or global financial company in such a dire situation.

Markets are not that stupid. There has to be a reason for this dramatic decline in DB stock.

(Please note: Ivan Martchev does not currently own a position in DB. Navellier & Associates, Inc. does not currently own positions in DB for any client portfolios.)

A Brexit Curve Ball

It was prescient to note (see May 23, 2016 Navellier Marketmail article “The Great Pound Mystery”) that the Brexit referendum outcome seemed a bit “too close for comfort” as there has been a dramatic swing in voter sentiment in the past three weeks. The Independent newspaper compiled many sophisticated polls and found that those voting against staying in the EU poll are more likely to vote than those who favor staying in the EU. So if one considers likely voter turnout, Brexit proponents now have a sizeable lead!

Brexit European Union Poll Table

Another issue that has persistently emerged is that the telephone polls consistently give “Remain” a higher rating than the online surveys. I am not sure if one can read from this that older people are more sensible, but there is a statistically-meaningful difference between telephone and online surveys.

How does that affect the British pound? The answer is rather negatively.

British Pound versus United States Dollar - Daily OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The GBPUSD cross rate – dubbed “cable” after the late 18th century exchange rate system when currency quotes travelled over a telegraph cable on the ocean floor starting in 1857 – had a major explosion of volatility on Friday given how the Brexit polls were swinging. Cable broke short-term support and looks likely to challenge the 30-year support of just under $1.40 before the referendum.

United States United Kingdom Foreign Exchange Rate Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

For over 30 years, $1.40 has held. Yes, we were briefly under $1.40 in 2008 and at other times, but cable didn’t stay below that level for long. The singular collapse of cable to $1.05 in February 1985 was when the U.S. Dollar Index soared to 160 (right now it is still under 100) and the U.S. dollar was generally viewed as overvalued leading to the Plaza Accord, which successfully popped the dollar bubble.

I think we will be trading into the $1.30’s on the GBPUSD cross rate before the referendum – if polls indicate a rising Brexit before the referendum – and that there will be a violent reaction lower if Britons vote to leave the EU. This would also be a negative political outcome for the euro, as Great Britain leaving weakens the EU and in that regard it also weakens the Eurozone, as it creates a bad precedent.

Breaking below monthly support at $1.40 right now looks like it has better-than-even odds. A vote for leaving the EU is likely to also boost the headline U.S. Dollar Index past the 100 level as the euro has a 57% weighting in the index.

United States Dollar Index - Monthly OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I think that the U.S. dollar rally is far from over, whether Britain leaves the EU or not. A Brexit vote should catalyze it or, if Britain stays in the EU, that should delay the dollar breakout temporarily.

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

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