Bear market for banks poses fresh Fed challenge

Out of nowhere, bank stocks in the US and western Europe are in a bear market.
Credit default swaps — instruments many had hoped never to hear mentioned again — are back on the agenda, as they show a greater risk of default for Deutsche Bank than at any time during the 2008-09 financial crisis.

This seems a long way from the concerns around China and the oil market that triggered the sell-off for world markets at the beginning of the year. But there is a common link: a rise in concern about central banks.

Markets do not believe that the Federal Reserve will follow through with higher rates, and instead believe that the tightening that has already happened will intensify deflationary pressures. Hence inflation break-evens — the implicit forecast for inflation over the next decade, derived from the bond market — have fallen to their lowest since 2009.

Most critically, this means that long bond yields have fallen far more sharply than shorter-term interest rates (a “flattening yield curve” in the financial argot). Yields on 10-year treasuries now exceed yields on 2-year bonds by less than at any point during the crisis. The yield curve is at its flattest in almost nine years.

This is dreadful news for banks, which make their money by lending money at high interest rates over the longer term while borrowing it at lower rates in the short term.

A steep yield curve was a recipe for boosting their profits and allowing them steadily to rebuild their capital. Now, their profit outlook has sharply worsened.

An extra factor comes from the Bank of Japan’s decision at the end of January to move to negative interest rates on some reserves. This was meant as a signal that it would do whatever it took to weaken the yen. But the yen is now stronger than it was before the BoJ’s announcement, and indeed stronger than it was at any time in 2015.

The message the market appears to have heard is that not only the BoJ but any central bank can keep stimulating the economy by cutting rates further into negative territory. And as negative rates would be surpassingly hard for banks to pass on to consumers, that damages their profit outlook still further.

Chatter about negative rates also explains the recent sharp rise in the gold price, which gained force after the BoJ announcement. Gold’s great disadvantage, that it costs money to hold, dissipates if it also costs money to hold cash.
Banks in the US had done much to repair their balance sheets. They are far stronger than they were before the crisis. But their health is important. As the Fed’s chair Janet Yellen prepares for testimony to Congress on Wednesday, she has yet another balancing act to pull off — she must step back from plans to raise rates much further, without stoking fears that negative rates are on the agenda.

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