- On the surface, banks look strong given the steepening yield curve and strong employment today.
- As we look closer, we can see that banks' and the monetary system's increasing dependence on the U.S. fiscal deficit and Federal Reserve may prove catastrophic.
- Job openings are high, but people aren't accepting low wages which will likely decrease corporate stability (given higher wages are not generating higher spending).
- Top U.S. banks have seen their total assets to liabilities (leverage) rise nearly to GFC levels since 2016.
- Other bank-sensitive measures including margin debt, mortgage debt, and asset valuations are also worse than they were in 2007.
While 2020 was dominated by high-growth technology giants, 2021 is proving to be a "reflationary" year. Long-term interest rates are on a strong trend which boosts the profitability of banks. However this also generally reduces equity valuations. This market regime benefits banks, commodity producers, and most capital-intensive firms while suppressing the value of high valuation non-cyclical firms such as technology and "safe" sectors. As such, energy, financials, and industrials led the pack during Q1 with double-digit returns while technology, utilities, healthcare, and consumer staples all rose by less than 5%.
Among all sectors, financials are the most impacted by the steepening yield curve. This can be illustrated via the strong relationship between the 10-2 Treasury yield spread and the 1-year price returns of the popular financials ETF (NYSEARCA:XLF):
As you can see, a steeper curve clearly indicates stronger bank returns. The reason for this relationship is very simple. Banks borrow short-term from savers (and the Fed) and lend long-term. As the difference between the two rises, banks are able to attain greater returns on capital (i.e., net-interest margins).
To make matters better, financial companies have lower valuations than the broader market. The yield curve has been notoriously flat over the past decade largely due to quantitative easing long-term Treasury purchasing activity from the Fed. Until recently, this (as well as trauma from the 2008 crisis) discouraged many from investing in the financial sector. As such, XLF has a lower weighted-average price-to-cash-flow ratio of only 11.7X and a forward "P/E" of merely 15X. Technically, this is the average valuation for the S&P 500 over a long-term time frame, but it still makes financials far cheaper than the S&P 500 today with a 30X+ "P/E".
On the surface, financials appear to be a great opportunity today as the market regime has finally turned in their favor. However, given the many extreme changes in the global economic and monetary environment, we must consider whether or not the "reflationary" regime is here to stay. Overall, it seems clear that inflation will continue to rise, but banks need inflation to rise with a strong economy in order to maintain their historically high leverage. If the economy falters and inflation remains where it is, then banks may find themselves in a difficult "stagflationary" environment.
A Look At The Bank-Fed-Treasury Marriage
In my view, the past few decades have seen a clear trend toward increasing dependence between banks, the Federal Reserve, and the U.S Treasury. More specifically, the increasing amount of Treasury assets on commercial banks and the Fed's balance sheets. See below:
As you can see, a growing proportion of total Federal Reserve and U.S commercial bank assets are being lent to the U.S government. This implies that private investors (people, hedge funds, foreign entities, etc) are not buying Treasury debt at the same level as are U.S banks and the Fed. This can be illustrated by looking at the proportion of the market value of Treasury debt held by the Fed and commercial banks. As you can see below, this has risen dramatically over the past year:
Currently, banks and the Fed own nearly half of the total government debt today. More importantly, they have been by far the primary funders of the 2020-2021 deficit surge. Foreign entities which were previously major buyers like China and Japan have not increased holdings over the past year. In layman's terms, only those who are effectively forced to buy U.S Treasuries are buying, everybody else is holding or selling.
Banks actually reduced Treasury assets early last year but reversed after the Federal Reserve made a temporary rule that allowed banks to buy Treasury debt and exclude those assets from their leverage ratio (which cannot be above a certain level). This was done in order to encourage U.S banks to help fund the current multi-trillion dollar fiscal deficit program.
Importantly, the Federal Reserve decided to not extend this relief program past March 31st, meaning banks may be needing to offload some of their Treasury bond assets. This is likely a contributing factor to the ongoing drop in the bond market. Overall, we can see that the appetite for Treasury bonds is extremely weak, meaning the U.S fiscal deficit may depend on permanent Q.E. In my opinion, this puts banks in a weak position as the value of a large portion of their balance sheet may be built on an artificial foundation.
Steep Yield Curve May Not Benefit Banks
Normally, a steepened yield curve increasing bank profitability as it allows them to lend at higher net interest margins. However, we must consider why the curve is rising as conditions today are not normal due to the extreme interdependence of banks, the Treasury, and the Fed.
Normally, the yield curve steepens during a recession and acts as a signal that the recession is ending. As the economy weakens, default rates rise and investors buy fewer financial assets which have a greater impact on riskier long-dated bonds. In truth, a steep curve is a sign of a weak economy while a flat curve is a sign of a strong economy. However, a flat curve forecasts a weak economy as bank returns on investment hit lows, and a steep curve forecasts a strong economy since it makes for an attractive lending environment.
To illustrate, see the strong relationship between permanent unemployment and the curve:
Unlike normal steepening periods, there has yet to be a long and lasting devaluation in financial assets. There has also only been a slight uptick in delinquencies and bankruptcies due to government stimulus. In my view, this fiscal stimulus and Q.E has obfuscated the underlying reality that is an overall negative economy.
Permanent job losses have remained high but have not continued to rise due to today's extremely high job openings. Once again, we have a situation in the labor market that is far from normal. There are many jobs being lost, many jobs available, yet there are few who are taking them. The reason is that workers are demanding higher wages as seen by the spike in wage inflation over the past year. This means that, while jobs are available, businesses will face increased costs and therefore lower profits as they increase pay. This is a clear-cut sign of wage-push inflation which will likely prove to be negative for banks.
Putting It All Together
In this article, I have touched on numerous points which I believe are key to the future of the financial sector. The bottom line message is that traditional economic signals may not work because the situation today lacks any (modern) precedent. Yes, unemployment is dropping and the curve is steepening, but unlike 2008, this may not be a sign that banks are in the clear.
Based on the evidence, it seems that unemployment will only decline at higher and higher wages. Put simply, people's appetite for work is on the decline. This recession is among the few that have seen job quits remain at peak levels (and actually have risen slightly). Personally, it seems the skyrocketing increase in retail investment activity may be psychologically driven by the fact that many would prefer to try to "get rich quick" than continue to work. Importantly, rising wages are not translating to rising spending (as is expected) and are instead translating to rising savings.
Put simply, people are making more and spending less. While that may seem distant to the financial sector, it will put pressure on corporate profits which are needed to pay off record corporate debt levels. As has been the case, it also means a lower portion of government spending will come from taxes, making the government dependent on the Federal Reserve. U.S commercial banks have never owned as much Treasury debt as they do today. If the curve is rising due to increased fiscal risk (suspected based on the lack of Treasury auction buying from most entities), then banks may face losses due to the ongoing devaluation. While many banks hedge some of this risk with derivative swaps, somebody holds that hot potato.
It is worth pointing out that the top five banks in XLF have seen their leverage return close to GFC levels since 2016:
With this in mind, a small negative catalyst such as Treasury auction issues, or a rise in corporate/household debt defaults could be deadly for the banking sector. With inflationary pressures on a firm rise (since they're backed by wages), the Federal Reserve's cards are limited without risking hyperinflation.
The Bottom Line
Overall, the financial sector today appears to be in a situation that looks strong on the surface but maybe incredibly weak in reality. The performance of their assets seems to be built on an increasingly weak foundation that requires more and more newly created money to remain afloat. Given rising inflationary pressures, the Federal Reserve's ability to create new money is waning. As this occurs, I believe we could see another collapse of the banking sector.
Looking closer at XLF it is worth pointing out that some of its holdings do not have these risks. XLF's top holding Berkshire Hathaway (BRK.B) as well as the fund's financial services and consumer finance holdings are only secondarily impacted by these risks. However, as proven by its ~80% drop during the GFC, the fund's value could see a large decline given a financial crisis. Considering much data I've seen (also including margin levels, valuations, and mortgage debt) is equal to or worse than it was in 2008, I would not be surprised if history repeats.
While XLF may continue to rise in the near term due to momentum, I am bearish on the ETF and the majority of its constituents. I cannot give a fair-value estimate given the immense uncertainty of this situation but let's just say that extreme leverage can bring extreme losses even with minor deterioration.
This article was written by
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