why are higher interest rates good for banks?

There are two factors involved:

behavior of bank managements:  To a considerable degree, commercial banks are able to use changes in interest rates to their money-making advantage.  When rates are declining, banks immediately lower the interest they pay for deposits but they keep the rates they charge to borrowers high for as long as they can.

When rates are rising, as is the case in the current economic environment, banks do the opposite.  To the degree they can, and given that most loans are variable-rate that is considerable, they raise rates to borrowers immediately.  But they keep the interest rate they pay for deposits low for as long as they can.

A generation ago, banks had a much greater ability  than they do now to maneuver the interest rate spread.  That’s because money market funds were in their infancy.  There were no junk bonds to serve as substitutes for commercial loans.  There was even a Federal Reserve rule, Regulation Q, that prevented banks from paying interest on checking accounts and put a (low) cap on what they could pay to holders of savings accounts.

Nevertheless, especially as rates are rising, spreads still can widen a lot.

economic circumstances:   bank lending business tends to tail off in recession, since most companies don’t want to take the risk of increasing their debt burden during bad times–even if the potential rewards seem enticing.  The credit quality of existing loans also worsens as demand for capital and consumer goods flags.

The opposite happens during recovery.  The quality of the loan book improves and customers begin to take on new loans.

stock market effects

The market tends to begin to favor banks as soon as it senses that interest rates are about to rise.  Wall Street was helped along this time around when perma-bear bank analyst Mike Mayo turned positive on the group for the first time in ages last summer.

After the anticipatory move, banks have a second leg up when the extent of their actual earnings gains becomes clear.  It seems to me the first move has already come to an end   …but the second is still ahead of us.

three steps and a stumble?

That’s the conventional wisdom (read: old wives tale) about Fed rate hikes and the stock market.  The idea is that the market absorbs the first two hikes in any rate rise series as if nothing were going on   …but reacts negatively on the third.

The third in this series of rate hikes will almost certainly come tomorrow.

The problem with this particular old saw is that there’s very little evidence from the past to support it.  Yes, there may be an immediate knee-jerk reaction downward.  But in almost all cases the S&P 500 is higher a year after a third hike than it was on the day of the rate rise.  Sometimes, the S&P has been a lot higher, once in a while a percent or two lower, but there’s no third-hike disaster on record.

Generally speaking, the reason is that rate rises occur as a policy offset to the threat of the runaway inflation that can happen during a too-rapid acceleration in economic growth.  As financial instruments, stocks face downward pressure as higher rates make cash a more attractive investment option.  On the other hand, strong earnings growth exerts contervailing upward pressure on stock prices.  In most cases, the two effects more or less offset one another.  (Bonds are a different story.  With the possible exception of junk bonds, all the pressure is downward.)

Of course, nothing having to do with economics is that simple.  There are always other forces at work.  Usually they don’t matter, however.

In this case, for example:

–I think of a neutral position for the Fed Funds rate as one where holding cash gives protection against inflation and little, if anything, more.  If so, the neutral Fed Funds rate in today’s world should be between 2.5% and 3.0%.  Let’s say 2.75%.  Three-month T-bills yield 0.75% at present.  To get back to neutral, then, we need the Fed Funds rate to be 200 basis points higher than it is now.

I was stunned when an economist explained this to me when I was a starting out portfolio manager.  I simply didn’t believe what she told me, until I went through the past data and verified what she said.  Back then, I was the odd man out.  Given the wholesale layoffs of experienced talent on Wall Street over the past ten years, however, I wonder how many more budding PMs are in the position I was in the mid-1980s.

–the bigger issue, I think, is Washington.  I read the post-election rally as being based on the belief that Mr. Trump has, and will carry out, a mandate to reform corporate taxes and markedly increase infrastructure spending.  The Fed decision to move at faster than a glacial pace in raising interest rates is based to a considerable degree, I think, on the premise that Mr. Trump will get a substantial amount of that done.  If that assumption is incorrect, then future earnings growth will be weaker than the market now imagines and the Fed will revert to its original snail’s pace plan.  That’s probably a negative for stocks …and a positive for bonds.

 

 

 

Trump and the big banks

banks and their social function

Banks aren’t ordinary corporations.  In addition to being private, for-profit organizations, they also carry out important social economic functions.  They’re the primary instrument the government uses to carry out national money policy.  Through letters of credit, they also underpin the workings of the international trade of multinational firms that is increasingly important for economic growth.

This is why the major banks are considered “too big to fail.”

bank failures

US banks have been on the brink of failure twice during the past hundred years–in the late 1920s and in 2007-09.  Both times this has been the result of rampant speculative financial market activity coupled with reckless lending, both driven by the search for earnings per share growth.

Glass-Steagall, and its repeal

In the 1930s, Washington enacted legislation, including the Glass-Steagall Act that barred the banks from non-banking activities (like brokerage, proprietary trading and investment banking).  The new laws ushered in a period of relative stability for the banks that lasted until the late 1990s, when their intense lobbying succeeded in getting Glass-Steagall repealed.

(An aside:  yes, the banks manufactured periodic crises through imprudent lending to emerging economies–the Walter Wriston-led binge of the 1970s being a prime example–but these were relatively tame in comparison.)

Less than ten years later, many big banks were broke.  World trade had come to a standstill as manufacturers refused to accept banks’ guarantees that shipped merchandise would be paid for (the worry was that the guaranteeing bank would file for bankruptcy while the goods were en route, reducing the shipper to being an unsecured creditor).  The deepest peacetime period of world economic decline since the Great Depression began.

This, in turn, spawned Dodd-Frank, the 21st century equivalent of Glass-Steagall.

repeal again?   so soon?

While it took more than half a century for the memory of the Depression to fade enough for Congress to consider removing restrictions on bank activity, we’re now less than a decade away from the 2007-09 collapse.

Despite this, despite campaigning on an anti-establishment platform, and despite warning that Hillary Clinton should not be elected because she would be a creature of the big banks, during his first few days in office Donald Trump is proposing to restore to the big banks the tools of self-destruction they have wielded to devastating effect twice before.

How odd.

 

the September 7th Job Openings and Labor Turnover Survey (JOLTS) report

The Bureau of Labor Statistics of the Labor Department released its latest JOLTS report on Wednesday.

The main results:

–nationwide job openings are now at 5.9 million, the highest figure in the 16 year history of the report.  This is substantially above the 4.5 million level of 2006-07.

–the rate of new hires has been flat for about two years at just over 5 million monthly.  While this is 5% – 10% below the rate of 2006-07, the very high number of job openings would have been consistent with an unemployment rate of 3% ten years ago.  This seems to me to be a point in favor of the idea that the main impediment to filling jobs is finding workers with needed skills.

–3 million workers are voluntarily leaving their jobs monthly.  This is a sign they’re confident of finding employment again without much difficulty.  That’s back to the pre-recession levels of 2006, and almost double the recession lows.

All of this argues that the US is at or near full employment.  On the other hand, however, there’s little sign of the upward pressure on wages that this situation would have produced in the past.

 

Whatever the reason for slow-rising wages, it seems to me there’s no reason in the employment figures for the Fed to maintain anything near the current emergency-room-low level of short-term interest rates.

 

 

the Federal Reserve and the election

The Fed is in an awkward position.

From a monetary stimulus perspective, the US has been in the equivalent of hospital intensive care for eight years.  In fact, by some measures the amount of stimulus being applied to the economy today is greater than it was during the depths of the 2008-2009 recession.

On the other hand, there’s the cautionary tale of Japan, which has been in quasi-recession for almost three decades.  At least part of this is due to three instances–one monetary, two fiscal–where the Land of Wa withdrew stimulus prematurely and nipped recovery in the bud.  Japan’s history also seems to show that reversing a policy mistake once made doesn’t undo all the damage of having made it in the first place.  This is the cause of the Fed desire to err on the side of having too much stimulus or having it for too long.

The Fed knows, too, that the legislative and executive branches in Washington are dysfunctional–that there’s no hope of government spending that would attack pockets of economic weakness through, say, programs to retrain workers displaced by technological advance or on repairing aging infrastructure.  This is despite the fact that extra dollops of monetary stimulus only improve the overall economic tone of the country and are less and less effective at addressing specific issues of great concern like chronic unemployment and bad roads.  On the other hand, the Fed is enabling this craziness by monetary accommodation.

On top of all this, the Fed is hemmed in by the presidential election cycle.  It typically does not want to make a move that could be interpreted as an attempt to influence the November election, either by lowering rates to make the economy seem more vigorous (favoring the incumbent) or raising them to make it seem less so (favoring the challenger).  In today’s case, of course, it has no scope to do the former.  And the Republicans are the party that wants to eliminate the Fed as an independent body (a lunatic move, from an economic standpoint).

So, what is the Fed going to do?

Its recent rhetoric says it wants to raise rates again before yearend.  There are three scheduled meetings left in 2016:  September, November and December.  It would seem to me that acting after either of the first two amounts to meddling in the election.  That leaves either an unscheduled meeting in August or the scheduled one in December.

 

 

 

Fed rate hike in June?

I think the Fed will raise the Fed Funds rate on overnight deposits by 25 basis points in June.

Five reasons:

–I think the economy is in considerably better shape than the consensus realizes

–We’ve been in intensive care for close to a decade.  We’re at the point where remaining in this state is more harmful than moving elsewhere in the hospital

–The Fed is, to some degree, a political animal.  It doesn’t want to be seen as attempting to influence the presidential election, which would have been a routine action by the Fed a generation ago

–Other than psychologically, it really doesn’t matter to the economy whether the cost of overnight borrowing is 0.25% or 0.50%

–Neither political party has a viable economic policy, in my view.  Leaving rates at zero prolongs the Fed’s role in enabling dysfunction in Washington (which seems to me to be the key issue in the election, whether ordinary citizens are articulating this or not).

 

the Fed in 1994

Maybe there’s nothing in past Fed rate raising actions that’s strictly comparable to the situation today.  However, the period that’s most often cited as a possible model is the one from May 1994 through February 1995.  During that time the Fed raised rates by a total of +2.25% in four moves–May, August and November 1994 and February 1995.

the Fed in 1994-95

The Fed moves themselves, and the stock market responses, played out as follows:

–the Fed Funds rate remains constant at 3.75% throughout 1993, a period when the S&P 500 rises by 9%

——–from the market high on January 28, 1994 through May 13th     S&P falls by -10%

May 17, 1994, Fed raises the Fed Funds rate by 0.50% to 4.25%

——–S&P 500 rises by 4% from May 17 through August 16

August 16, 1994, Fed raises the Fed Funds rate, again by 0.50%, to 4.75%

——–S&P 500 is flat from August 16 through November 15

November 15, 1994, Fed raises Fed Funds rate by 0.75% to 5.50%

——–S&P 500 rises by 4% from November 15 through February 1, 1995

–February 1, 1995Fed raises the Fed Funds rate by 0.50% to 6.0%–and stops

——–S&P 500 rises by 29% through yearend 1995.

the pattern

aggressive rate increases every three months, totaling 225 basis points

the S&P 500 falls in ahead of the onset of rate moves, wobbles briefly as rates are raised, goes sideways/up until the next rate increase–and advances strongly once the Fed stops

relevance for today?

Entering 1994, real GDP in the US was growing at about a 5% annual rate (or about two percentage points above the maximum sustainable growth rate)–and accelerating.  So the Fed acted very quickly to slow the economy down.

We’ve got a very different problem today.  Growth is barely at trend.  Expansionary monetary policy has been exhausted, and has overstayed its welcome simply getting us to this point.  Washington has consistently failed to use fiscal policy to support GDP growth, and shows no signs of wanting to live up to its responsibilities.

The purpose of Fed Funds rate increases this time is to minimize economic distortions that happen when too much money is sloshing around in the system (think:  oil and gas junk bonds with no restrictive covenants), rather than to slow down runaway growth.

In 1994, the S&P sagged significantly in advance of the Fed’s initial move.  The index also stumbled slightly around the time of later rate increases.  But, apart from day-to-day wiggles, the index went sideways to up during the rate rising period.

Did the Fed design its rate behavior with an eye to keeping the stock market stable back then?  That’s not clear.  However, that certainly was what resulted from Fed action.  And avoiding stock market declines was clearly Allen Greenspan’s modus operandi in the Fed’s subsequent rate policy.

Today’s Fed has been quite explicit in its intention to avoid market turbulence that might occur were rates to rise too fast.  1994 shows us, I think, that it can accomplish that objective.  The Fed already seems to be signalling that its original plan to raise rates by 100 basis points this year is being revised downward.

That period also suggests that the major stock market adjustment comes very early in the process.  Arguably, that’s what the declines of August-September and November-January are all about.