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Gone big. Stocks extended last week’s rally Friday on continued hopes of a stimulus package… eventually. President Trump’s health appears to be improving adding further hopes that the therapy pipeline will soon yield some positive treatments, further adding positivity to investor sentiment.
N O T E W O R T H Y
On the banks. Banks have been in a precarious position since the financial crisis. The S&P500 tumbled nearly -45% in late 2007 through 2008, but the banking sector struggled even worse, dropping around -81% before bottoming out in 2009. In the wake of the Financial Crisis, the sector rallied along with the broader market adding +365% through last week’s close, but the S&P500 added +413% through the same period. Not only has the sector underperformed the broader S&P, but it has proven to be far more volatile. One of the biggest driving factors for the sector is, as one would expect, interest rates. A quick reminder, banks make money when they can lend out money at a higher rate than they can borrow it. While low interest rates on their own certainly challenge bank earnings, it is the slope of the yield curve that has the biggest impact. Banks tend to borrow money in short maturities and lend it out in longer maturities. An example is a bank borrowing money in short term CDs and lending it out in home mortgages. The spread between 30 day and 30 year maturities has a direct impact on a bank’s lending margin. The spread between 3 month and 30 year yields peaked around +4.6% in December, 2009 and, albeit bumpily, trended down for the better part of the decade that followed. It bottomed out late last year at around +0.28%. Another way to express that move is to say that the yield curve flattened in the period between 2009 and 2019. Many people believe that the flattening of the curve was caused by the Fed keeping statutory rates low for so long, however it was in fact, the market itself that really impacted the yield curve. When the Fed lowers rates, it impacts short term yields at the front of the yield curve, which actually serves to steepen the yield curve. The back end of the yield curve, 5 years through 30 years, is controlled by the markets. Remember that when bond investors expect the economy to be in a rough state they buy bonds, thus lowering longer term yields, which ultimately causes a flattening of the yield curve. Prior to the COVID crisis, the US economy was in the midst of the longest economic expansion in modern times. Many bond investors began to anticipate an economic pullback starting in late 2015 and the buying that ensued, served to accelerate the fall in longer maturity yields…thus flattening the yield curve. There is another side of the yield curve story. When bond investors expect the economy to expand they sell bonds, increasing longer maturity yields, thus steepening the yield curve. The higher long-term yields compensate investors for the expected inflation that comes with economic expansion or vast economic stimulus. Though we are still in the midst of the pandemic, bond traders have been pushing longer yields higher in anticipation of the inflation which is expected to come from the CARES Act and the follow-on stimulus expected in the months ahead. Though a curve steepening will certainly be welcomed by banks, there are many other factors that will impact the group’s financial health in the months and years ahead. In addition to lending, banks make revenues from fees and commissions. Lower borrowing rates have incentivized many companies to rush in and borrow money in the bond markets and the banks that facilitate the offering earn fees. Commercial banking transactions that occur directly between the banks and corporate borrowers also provide fees to the banks top line. Finally, the increase in public stock market offerings that come with strong equity markets also provide fees to banks that operate in the space. Lastly, there is the regulatory environment. In the years following the Financial Crisis, lawmakers imposed stricter regulations on banks in order to avoid another 2008-style meltdown. Those regulations have certainly cost the banks earnings, which also contributed to the industries underperformance in recent years. When the Republicans swept the House, the Senate, and the Presidency in 2017, they quickly cut back on many banking regulations, a move which certainly gave the industry a boost. Currently, it appears that the broader market is expecting some sort of Democratic party success in the election, which would mean greater spending and a steeper yield curve, which will be welcomed by banks. However, Dems are more likely to favor additional banking regulations, which may dampen the industry’s expected gains. Finally a growing economy, an advancing stock market, and low rates ensures that origination fees, commissions, and consulting fees will continue to roll in the years ahead. This week, we begin Q3 earnings with the banks. JP Morgan Chase kicks it all off tomorrow morning followed by a bevy of who’s-who in the banking world. Rest assured, investors will be eager to hear about not only non-performing loans, but also about expectations for increased loan margins… and fees.
THE MARKETS
Stocks rallied on Friday on further hopes of stimulus out of Washington DC. A “…GO BIG” Tweet by the President certainly helped the bull case. The S&P500 rose by +0.88%, the Dow Jones Industrial Average advanced by +0.57%, the Russell 2000 climbed by +0.55%, and the Nasdaq Composite Index jumped by +1.39%.
NXT UP
- Today will be a quiet day with many Government agencies on a banking holiday celebrating Columbus/Indigenous Peoples Day. Bond markets are closed.
- The remainder of the week will be packed with earnings along with more Fed speakers, inflation numbers, regional Fed reports, Retail Sales, Manufacturing Production, weekly employment numbers, and University of Michigan Sentiment. Please refer to the attached economics and earnings calendars for details.
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