Banks For The Memories

By: Michael Ashton | Wed, May 4, 2011
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Trading continues to be lethargic. This isn't just true of this week - Employment weeks can be notoriously quiet - but of markets generally over some period of time. NYSE Composite total volumes haven't exceeded 1bln shares this quarter, the longest streak of failing to do so in many years. One reason that the VIX (equities), the MOVE (Treasuries), and other volatility indices are so low is not complacency - although there is some of that as well - but the fact that the realized moves have been so small for so long that it is just too hard for an options trader to keep a long position subject to the drip, drip, drip of time decay. When I first got into the markets and was trained as a technical analyst, we considered this 'coiling' and a sign that a big move was near. That may no longer be true. It may simply be that the market has lost enough liquidity, due to Dodd-Frank, rules about naked shorting, and capital constraints, that volumes and volatility are moving to a lower equilibrium.

This is, of course, bad news for the banks. We have noted this week how banks are being forcibly under-levered because of the excess reserves in the banking system. That's one element of the DuPont model. Lower volumes are a second component. Unless banks can charge much fatter margins (and the chance of that is the only thing that's fat), earnings are doomed to decline. This has been apparent for a long time, but for a while these companies can keep hitting targets by drawing down reserve accounts (evidence the trend over the last year to sharply reduce credit reserves, supposedly because of improved default experience). The mathematics in the long run are powerful, however, and this is a big reason that while the S&P has recovered 75% of its 2007-2009 decline, the NASDAQ Bank Index has recovered only 28% of its dive (see Chart).

NASDAQ Bank Index
For all the tender mercies of the central banks, the non-central banks are still weak.

No one cries for the banks. But healthy banks matter. I present the chart above not to bury the banks but to point out how poorly they've done even with the Fed, ECB, and other monetary authorities working very hard to engineer a very steep yield curve - historically, the way that banks have gotten healthy again after bad periods. It isn't American banks only that remain weak (and by weak, I don't mean so much the balance sheet. The balance sheets have definitely improved, but the long-term growth rate of the company is what allows them to bear up in a crisis and recover after it. It's the economic strength, not the accounting strength, I'm talking about here). European banks have similar issues, and that matters because they're also all stuffed with dicey sovereign debt that is allowed to be carried at par. We are, indeed, much closer to a second banking crisis than we would like to think, and this is the significance of comments like those last week from ECB Executive Board member José Manuel González Paramo. In discussing the possibility of simply restructuring Greece's sovereign debt - never mind default - he said "Any debt restructuring would imply the breach of legal obligations, which most likely would have a more negative systemic effect than the Lehman catastrophe." One reason for this is that the banks and the ECB both own lots of Greek paper considered legally to be worth par. And there's no way it's really worth par. To a strong banking system, a Greek default or restructuring would be damaging but survivable. In the banking system's current state? Paramo may not be far wrong.

It would help banks to strengthen, of course, if the economy were to continue to strengthen (it would also help them if inflation rose, because that would increase the value of loan collateral, such as housing, that currently provides insufficient coverage for loan exposures). Today's economic data in isolation are not encouraging on that score. The ADP number was soft, although close enough to expectations at 179k (198k was expected). More surprising was the Non-Manufacturing ISM report, which printed 52.8 versus expectations for 57.5. The Non-Man ISM is not usually a market-mover, but this big of a miss had some market repercussions. I was right that the markets had more downside than upside: stocks lost 0.7% while 10y notes only rallied 3bp to 3.22%.

A time-series chart of the Non-Man ISM is below. The number returned essentially to last February's level, mainly because of a sharp decline in the New Orders subcomponent to 52.7 from 64.1

ISM Non-Manufacturing
Bad drop, but it's probably not the start of a second leg down. We hope.

Now, keep in mind that this is a relative-change measure, not an absolute measure. That is, the fact that it is at the level of Feb 2010 doesn't imply activity is at the level of a year ago, but that the economy is improving as fast as it was in February last year - which is to say, it's not improving very much at all at the moment. That beats getting worse, but with the Fed about to stop its bond-buying program and with "issues" still to solve in Europe it would help to have the economy starting to kick into high gear right about now. And it ain't. (Hey, but thanks for that $1.5 trillion. It really did a lot, didn't it?)

These are only two minor reports, although in general the disappointments have been on the downside for a while now (as I showed on Monday). A cheerful Initial Claims report tomorrow (Consensus: 410k from 429k) and a strong Payrolls number on Friday would go a long way to dispelling concerns raised from these minor reports. But Claims has actually been part of the problem. Economists were initially encouraged last November when Claims finally moved consistently below 440k. With some chop, they continued to decline until February and March, when for the most part Claims were below 400k. recently, though, they've risen again - to 416k, 404k, and 429k the last three weeks - and after revisions Claims have exceeded the consensus expectations for eight consecutive weeks (actually, on April 1st they matched expectations exactly).

Also due out tomorrow is Non-Farm Productivity and Unit Labor Costs for Q1. It isn't an important number although if ULC exceeds the +0.8% forecast by very much it will get some of the wage-push inflation guys excited.

Bonds continue to do very well despite the poor seasonal pattern for this time of year, but gains below 3.20% yields on the 10y note will get increasingly difficult without a really bad Employment report on Friday. I would expect some duration risk to be taken off the table on Thursday. Commodities have gotten smacked around for a couple of days. Initially it was a Silver thing, then a precious metals thing; today Grains, Livestock, Softs, Precious and Industrial Metals all fell. But with the dollar weak and real interest rates so low, I don't think commodities are going to take a serious hit.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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