November 2024 – Post US Election: Picking up Pennies in Front of Steamrollers and Walking Past Dollar Bills
This is my first column since the conclusion of the 2024 US election. A lot has changed in the opportunity and risk landscape for US banks. US bank equities were the best performing sector in the S&P-500 immediately following the Nov 5th US election result. The view that renewed US bank deregulation and desupervision, coupled with a more accommodative environment for bank M&A, will improve US bank stock performance appeared to inform this price action. These topics, indeed, are important factors for US bank performance.
Here is the S&P-500 bank sub-index’s price performance (white) compared to its 12-month rolling forward earnings per share (EPS) estimate (red). The post-election jump in US bank stocks looks a bit lofty though forward EPS also appears to be the highest since 2004 for US banks. In sum, there is a lot of good news in US bank equity prices.
The situation reminds me of a lecture I gave to students on corporate credit this fall. I emphasized taking the time to sort out what the macro environment means for a sector and a given credit. We talked about how some analysts are eager to skip this step and go straight to “the real work” of analyzing an entity’s balance sheet, the strategy, the management team. I have seen this a number of times in my career. I try to remind students that both top down and bottom up steps are crucial and having a thoughtful understanding of the macro outlook is needed to painting a correct and nuanced “credit mosaic.”
Long-dated US Treasury yields and interest rate volatility were elevated before the US election due the Fed’s unfolding policy error of easing monetary policy even as fiscal policy eased into the election– a topic I discussed in my first column for BTRM in September. I argued that rates could remain higher for longer unless a lower US budget deficit allows the Fed to meaningfully cut US interest rates and get the economy back to a lower interest rate/ lower growth equilibrium. But for now, we remain in a regime of upward pressure on the 10-year Treasury yield and elevated US interest rate volatility which are not positive for the US banking sector (nor commercial real estate).
Going back to US bank equity valuations, those regional banks who used the period immediately following the US election to issue more equity – sincere congratulations for a smart play! My only concern is that a number of these banks appeared to issue enough equity to merely rebuild their capital to a median level in light of balance sheet repositioning and realized interest rate losses. They did not take this window of opportunity to grow their capital to a superior level at a time when US economic policies appear poised to change significantly, and volatility is rising. So the election price action was helpful to some regional banks’ capital and earnings, but not revolutionary.
That said, it truly is good to see some banks repositioning the balance sheet for interest rate losses. Such an activity can be quite sensible. However, if a bank is repositioning the balance sheet that means the bank’s ALCO, senior management and/or the board made errors previously. Mistakes happen, but did the bank team extract the relevant lessons?
Why Do Some Banks Still Pick Up Pennies in Front of Steamrollers in the Bond Market?
A key lesson of 2023 was that banks need to be far more attentive to being short volatility and ensuring they receive adequate compensation for options embedded in their balance sheets. Specifically, banks need to be mindful of the embedded optionality in their assets (agency MBS, mortgages, undrawn commitments) and liabilities (deposits) and make sure that they are managing these short volatility positions appropriately.
The MOVE index which measures implied volatility on options on a basket of Treasury futures closed Friday at 102, or 10 points above its long-run average. At 102, the MOVE is priced consistent with about 6 bps of daily volatility in US Treasuries over the next month. While the MOVE index has come down since the US election, US interest rate volatility appears to have returned to pre-global financial crisis (GFC) levels.
The chart below shows data from the Federal Reserve’s H.8 release on the share of agency MBS to total assets for “small” and “large” US banks.[1] Large US banks (yellow) allowed their agency MBS holdings to grow to a record 16% of their balance sheet as the MOVE plumbed record lows during the pandemic. Large US banks currently still hold almost 15% of their balance sheet in agency MBS. Large US banks have been agency MBS buyers in 2024 despite the rise in the notable rise in volatility as captured by the MOVE. At comparable levels of the 10-year Treasury yield and the MOVE in the early 2000s, large US banks’ share of balance sheet devoted to agency MBS was about 40% lower, or 9% of large bank balance sheets vs 15% today.
Small US banks’ agency MBS holdings (white line) declined more meaningfully than large bank holdings this Fed cycle and today are far lower at 9% of total balance sheet. However, like large banks, small banks also are increasing the agency MBS’ share of their balance sheets again. Is it plausible to think that interest rates and rate volatility are coming down any time soon?
Meanwhile, data on Bloomberg’s agency MBS index would suggest that risk adjusted returns for agency MBS are not attractive on a long-term basis. The chart below graphs the option adjusted spread of the agency MBS index, its option adjusted duration and the 10-year Treasury yield. Today the option adjusted spread (OAS) per unit of option adjusted duration (OAD) is just 7 bps. In the period preceding the global financial crisis (GFC) and the Fed’s use of quantitative easing (1995-2005), an OAS to OAD ratio of 7 bps was never observed. What today the market seems to accept as normal pre-GFC would have been considered ridiculously low. For this 10-year Treasury yield and level of the MOVE, banks should be seeking higher returns from agency MBS for the risk.
After the GFC, super low interest rates and Fed quantitative easing drove down the compensation for US interest rate volatility. Some banks still seem to be pricing agency MBS as though we are in a near zero rate world and the Fed imminently will resume buying duration and driving long-term interest rates down.
Until the US budget deficit declines meaningfully or the US economy enters a recession, it is difficult to see the US economy shifting to an equilibrium of meaningfully lower interest rates and/or an restart of QE consistent with this kind of pricing. Since the pandemic, the dominant role of fiscal policy relative to monetary policy has continued to grow. Data that came out last week from the US Treasury showed that the US budget deficit to GDP widened to 6.9% in October, up from 6.3% of GDP in September.
Will there be any fiscal consolidation from the next Administration which could allow the Federal Reserve to meaningfully cut interest rates in 2025? President Trump has yet to announce his choice for Treasury secretary and configuration of his broader economic team. But for now the Game of Thrones among potential Treasury Secretary candidates and senior economic advisors for the Administration continues as markets watch.
Currently, it seems most plausible that the US budget deficit will stay elevated and the trends of higher US interest rates and interest rate volatility will continue in 2025. Fiscal largesse has been an enduring feature of both Democratic and Republican administrations.
At the same time, expected changes in President Trump’s approach toward immigration and tariffs in 2025 should give a boost to Q1 GDP. Expectations of deportations could trigger labor hoarding among firms. Businesses may increase their inventories in an effort to front run tariffs. Hopefully Fed Chair Powell will recognize that even if the specifics of the next administration’s immigration and tariff policies are not known fully yet, US businesses may act and not wait to analyze the fine points. The Fed also needs to be far more cautious of policy errors on inflation given both the recent election outcome and that the Administration may blame upside inflation surprises on the Fed. Based on what we know today, the FOMC should pause at its December meeting. Of course, such a pause both would increase interest rates as a December rate cut is fully priced out and increase interest rate volatility.
Why Do Some Banks Walk Past Dollar Bills?
It is odd that some banks continue to grow their holdings of agency MBS securities which are short volatility when volatility is elevated and may rise further. It is almost as startling that more US banks are not considering inflation adjusted US Treasuries (TIPS) to hedge risks related an upside surprise in inflation in 2025. TIPS indexation to CPI fully incorporates urban CPI developments on a non-seasonally adjusted basis (CPI-U NSA) with a 3 month lag. Therefore, TIPS would stand to benefit from any bumps in inflation due to significant new tariffs or labor shortages.
The 5-year TIP real yield at 1.90% is well above its long run average of 1%, though down from elevated 2023 levels when the Federal funds rate was higher. Nonetheless, as the chart below illustrates, TIPS provide a welcome hedge against unexpectedly elevated inflation which has periodically driven the inflation adjusted yield of the nominal 5 year Treasury into deeply negative territory.
Broadly, off-the-run TIPS currently trade at attractive real yield levels and the value proposition of TIPS with short-dated maturities can be significant in some cases. TIPS with maturities less than one year tend to trade at elevated real yields and front end breakeven inflation can trade at unrealistic low levels. To give a concrete example, the April 2025 TIP is priced with a 2.83% real yield. A comparable maturity nominal Treasury bill yields 4.37%, implying breakeven inflation of 1.54%, even as October CPI-U NSA was 2.6%.
These dislocations in short-dated TIPS pricing seem to be due to the presence of bond index funds who dump TIPS with short-dated maturities less than one year while money market mutual funds eschew short-dated TIPS given their inflation-adjusted principal values can decline (though not below par) if deflation – an unlikely risk for 2025 — were to take hold.
Admittedly, TIPS are not nirvana. They are significantly less liquid than nominal Treasuries and also have a nominal duration that is more to difficult to pin down (hint: read up on TIPS’ yield beta) than nominal Treasuries given that TIPS are quoted in real yield terms, but interest rates we observe in the market are nominal.
Perhaps most banks are not so familiar with how TIPS work? Certainly broker dealers may have limited incentives to explain or recommend Treasury trades to clients as opposed to agency MBS, municipals or corporates where bond pricing is more opaque and dealers can earn higher spreads. However, at these real yield levels and with unexpected inflation pressures a worry for 2025, a portion of a bank’s securities portfolio sensibly could include an allocation to a ladder of TIPS with maturities inside of five years. Yes, it may involve some extra learning and/or effort. But, it is always better for banks to pick up dollar bills as opposed to pennies. In this environment, short or intermediate dated TIPS may be worth a second or even first look for banks’ securities portfolio.
[1] The large US bank aggregate in the H.8 data currently corresponds to US banks with assets > $150 billion.
