The other kind of Fed mistake

Good morning. Why is no one talking about asset bubbles? Maybe there is only room in Wall Street’s collective brain for a set number of possible disasters, and “inflation” and “Fed mistake” are hogging all the cognitive real estate. But everything is expensive, and there is just the faintest whiff of fear in some markets. Bubbles seem like a topic worth raising again. I try to sneak it in today. 

The other kind of mistake

You just can’t please everyone. There is an emerging consensus, as I wrote on Thursday, that the Fed is preparing to make a mistake — tightening rates too early and too fast, thereby killing economic growth while it is still in the cradle. Some people disagree, though. Their view is not that the Fed is muddling along OK (my rather lonely opinion), but rather that the Fed is actually making the opposite error — not tightening soon enough. 

Mohamed El-Erian, writing in Bloomberg earlier this week, argued that the simultaneous rise in consumer and producer prices “suggests that realised inflation is being accompanied by additional inflation in the pipeline”, while the Fed is being maddeningly vague about when it will react. This could mean trouble:

The facts on the ground . . . call for the world’s most powerful central bank to start easing its foot off the stimulus accelerator. For example, it should cut back the mortgage component of the $120bn of monthly asset purchases, an element fuelling an already red-hot real estate market that is pricing many Americans out of new houses without any notable economic benefit elsewhere. By refusing to do so, the Fed runs a higher risk of having to slam the policy brakes down the road. This comes with the threat of the Fed inadvertently engineering a recession.

El-Erian thinks abrupt tightening will crimp growth only if “market accidents don’t happen first, the probability of which is also increasing”. (It seems to me that when markets are “red hot”, a recession without a market accident first is quite unlikely. An overheated market is a great leading indicator of, and catalyst for, a recession.)

One might argue El-Erian and the other Fed-mistake-anticipators are not so far apart. They both worry that the Fed will overtighten. The difference, though, is that instead of yelling “don’t touch that dial!”, El-Erian is shouting “turn it a little now so you don’t have to turn it a lot later!”

Rick Rieder, who runs fixed income for BlackRock, hits some of the same notes as El-Erian. Writing after the hot CPI print, he said:

Policy adjustments that are intentionally late . . . can create distortions in the economy and markets that (ironically) risk undermining the very successes that policy has achieved up to this point . . . we need look no further than the housing market to see how this plays out. As a result of huge price gains through the pandemic, accompanied by easy policy, new home sales have fallen 23 per cent . . . The Fed should outline the tapering programme (especially in mortgages), as we appear to already be at, or close to, maximum employment (at least as characterised by job availability) and simultaneously may be at risk of overheating in pricing.

I was struck by the focus on “distortions” rather than on what seems to me to be the clear and present danger of an explosion in some corner of the market that scares everyone, leading to general flight from risk, negative wealth effects, cats and dogs living together, and recession. So I called Rieder up.

He emphasised that there were three things he was worried about: inflation being stickier than expected (he’s looking closely at the way service industries are passing on costs to consumers); higher prices for basics like food turning into a regressive tax that ultimately kills demand; and high asset prices stifling certain markets, as in the housing example. 

Interestingly, he sees low Treasury bond yields as an example of this last point. Everything else is so expensive, and everyone has made so much money, that the safety and liquidity of a Treasury that yields something, if not very much, is appealing. “I look at high-yield bond deals at 2.5 per cent, and Treasuries at 1.3 don’t look all that bad,” he says. “Real rates and Treasuries are priced wrong, but they’re liquid.”

But if we are seeing what looks like a flight to the safety of Treasuries from overpriced assets, shouldn’t we be worried about a crash in risk assets? Rieder thinks that equity valuations are not that high and the stock market will move higher. Furthermore, the abundant liquidity in the current market means that gradual tightening “just is not that scary”. “But the longer you let it go, then [the Fed] has to move faster and harder, that is when it hurts the market. I don’t think we are there yet, but every month that goes by you create a riskier proposition.”

Why aren’t bank stocks getting hit harder?

If you are one of those people who think the Fed is going to kill growth, and rates are going to remain low for the long term as a result, you probably don’t want to buy bank stocks.

People used to talk a lot about how bank profitability was driven by the slope of the yield curve, because banks fund themselves at the short end and make loans at the long end. This isn’t really true any more (banks don’t use as much short-term funding as they did, and thank God). Now it’s about the level of rates, and short rates in particular, as most loan products are priced on the short rates plus a spread. 

The excellent bank analyst Brian Foran of Autonomous sums it up this way: if rates rise by 1 per cent across the yield curve, the average bank’s profits with rise about 15 per cent, with two-thirds of that bump coming from higher short-term rates.

The rates on long-term bonds (in theory) tell us about the long-term path of short-term rates. So the recent fall in the 10-year is telling us (in theory) that short-term rates will be low for a long time. Bad news for banks!

But, oddly, bank stocks are not doing all that badly. Here is the stock performance of the six biggest since last November, when they came into vogue with the “reflation trade” (data from Bloomberg):

The stocks rolled over when 10-year yields did, back in May, but the damage has not been all that bad. They are still miles above the pre-reflation trade lows. 

The largest banks have reported second-quarter earnings in the past few days, and the results were better than expected. Much of that is down to excellent credit quality — Covid-era loss reserves being released and low loan charge-offs. Foran believes that credit quality accounted for 80 per cent of the earnings outperformance. Trading desks didn’t do well, but a boom quarter in dealmaking fees made up for that. Loan growth is showing very tentative signs of recovery, led by credit cards. 

The markets are not quite buying it, though. Here is a classic bank chart, which plots banks’ return on tangible equity (the most basic measure of bank profitability) against price-to-tangible book ratios (the most basic measure of their valuation). All data comes from the banks themselves:

Usually there is a tight linear correlation between returns and valuations (so all the banks cling to a straight, upward-sloping trend line). Right now they are all over the place. The very high returns at Goldman and JPMorgan should force them way to the right, that is, give them higher valuations. Citigroup and to a lesser extent Bank of America seem too far to the left, too — why haven’t their high returns pushed their valuations higher?

What the chart is telling you is that the strong investment banking results at JPMorgan, Goldman and Bank of America are unlikely to last. The market has more confidence that the big regional banks like US Bank (USB), Truist (TFC) and PNC, which depend less on capital markets, will be able to maintain their returns. Morgan Stanley’s wealth management business is a stabiliser, too (Wells Fargo is a whole different conversation).

To my eye, though, all the valuations look high, if we think the reopening economy will quickly fade back towards sluggish pre-pandemic normality. Credit is not going to get better. If growth is soft, why would loans grow? Especially given that bond markets are handing out all but free money? It is not obvious to me why investors are willing to pay 2 times book value for banks right now. That’s close to the top of the historical valuation range.

On this question, Charles Peabody of Portales Partners makes an encouraging point. Bank stocks traditionally do well at the beginning and end of economic expansions, he notes. At the beginning, improving credit quality pushes their earnings up, and at the end, loan growth does the same. In the middle of the cycle, they tend to sag. So:

“I think this is a classic mid-cycle correction and eventually we will get all the things that people are disappointed we are not getting right now — higher rates, loan growth, and so on.”

In a world of dreary data, then, bank stocks’ high valuations and relatively resilient stock prices are sending a positive message: this, too, shall pass. The inflation kerfuffle and the bond yield collapse may just give way to the renewed growth we were hoping for a few months ago.