My Two Cents On Nonsense
I had not planned to write tonight, but there was too much that happened today, and too much that is likely to be misunderstood and misinterpreted. Not, necessarily, that what follows will help that situation, but I felt a need to add my two cents (which, don’t forget, is two cents more than you paid for it, so you’re two cents ahead no matter what).
Let us start with the good news, however. Retail Sales exceeded expectations, with +0.9% ex-autos and even +0.6% ex-autos and gasoline (yes, higher gasoline prices show up as higher retail sales), with upward revisions to both series last month. Clearly, retail sales are doing better than expected and are a bright spot; as I’ve said for a while, the trick here isn’t figuring out that the economy is improving, but figuring out whether that improvement will be consistent and can be built on. The jury is out on that one, and I will say that I am not exceedingly optimistic. But that is not today’s trade!
The Fed met today, and the market actually took a statement that was nearly empty of significance and wrung drama out of it. Stocks leapt, because while the Federal Reserve acknowledged that the economy was improving there was no sign of any wavering in the resolve to provide easy money for the next couple of years. They were correct to do so (based on that interpretation), although the curious thing was that commodities rose only sluggishly, and precious metals actually dropped 1% or so. That’s confusing because easy money for a couple of years ought to have the most direct effect on the prices of commodities. The dollar strengthened, though, partly because of the strong economic data, and this blunted some of the natural upward pressure in this circumstance.
Bonds sold off, also correctly, on the lack of any sign from the Fed that QE3 is being considered in any form. The question is, when the Fed is done with Operation Twist II, who will be buying the 10y note at 2%? China recently announced a large trade deficit on the basis of declining exports; this is probably a one-off but it raises the question of whose surplus will be dedicated to buying Treasuries (obviously, there is a net surplus somewhere; every country can’t run a deficit! We just don’t know whether the other surplus countries will prefer to buy Treasuries). Accordingly, the 10y note yield rose to 2.125%, up 9bps to the highest yield since the false breakout in late October last year (see Chart). While it is probably early to say that this will lead to a big rise in rates, every trader knows the old saw that the market will find the greatest pain, and right now there is a holder of trillions of dollars of long Treasury securities who has no way to sell them and is growing tired of supporting the market at these yields.
The rise in yields was predominantly due to a rise in inflation expectations; indeed, over the last week 10-year yields have risen 18bps; 16 of them have come from an increase in 10-year inflation expectations and only 2 of them from a rise in 10-year real yields. See the chart below of 10-year inflation breakevens, which are back at the highest levels since August.
This is significant, especially as it extends, because the Fed continues to profess that one reason they are not concerned about the rise in core inflation is because “inflation expectations are contained” and this is less and less true, whether you’re looking at market indications or listening to retail customers (whose perceptions of inflation turn out to be driven quite significantly by fluctuations in gasoline prices). Today retail gasoline prices reached $3.80 nationally, and given the usual lags in wholesale-to-retail transmission, it appears that record prices above $4/gallon are likely in the next month or so. Whatever the implication for economic growth (negative, but probably not as bad as the first time we saw those prices) and core inflation (no real effect), the effect on inflation expectations will be large and not helpful for either the Fed or a Treasury which still has a few trillions in securities to unload this year.
And this takes us to the final, and most interesting, event of the day. It began when JP Morgan trumpeted a nickel increase in its dividend and a $15bln stock buyback. My first reaction was that this is not a phenomenon you tend to see in bear markets or early in bull markets, but rather in mature bull markets. Firms have a marked tendency to buy stock back when it’s expensive, not when it’s cheap, and an even more marked tendency to announce a buyback when they want a stock price supported. An announcement of a buyback program is not a promise to buy, and often no stock is actually bought. It is only an announcement of an intention to buy, which the firm need not honor. And this is a bank. Anyone with even a passing knowledge of Basel III knows that banks are going to be raising Tier 1 capital – especially in Europe, but in the U.S. as well – for a while. There is no way that banks, whether or not they feel overcapitalized by 2000s standards or not, are actually going to be buying back large chunks of stock. So my second thought was “wow, are they actually going to scare up the stock so that they can sell more? That can’t be legal.”
Moments later, we found out what the real point was. It seems the Fed had completed the stress tests and informed all of the banks a couple of days ago (it’s unclear when), and were going to make a public announcement on Thursday.
Sidebar: This is why people think that Wall Street is run by a bunch of crooks. The moment that banks had this information, they were in possession of material nonpublic information that should have been immediately released if the banks were going to prepare any offering in their own securities. Whether the Fed says they can or can’t, the information must be released. And here is one positive checkmark for JPM: they announced that the Fed had approved their buyback and dividend plans in the context of passing the stress test. But thanks a lot, Fed, for putting banks in the awkward position of having to choose between ticking off the Fed, or ticking off the SEC. And great job, bank managements, for mostly choosing to keep a secret that makes you look like a member of an elite club/secret cabal, rather than choosing to release the information. Good job, JPM. (But I’m not done with you yet).
So, the Fed decided that they needed to immediately release the stress tests results, early. Well, not immediately; they decided to wait until 4:30ET, after the markets closed to retail investors, because golly it would be too much to ask to let people get the information when the markets were open. Sidebar: this is why people think the Fed is run by a bunch of crooks who are in bed with the Wall Street crooks. Who is running the PR at the Fed?
Bank of America bravely followed JP Morgan through the breach to announce that they, too, had passed the stress tests. US Bank announced a share buyback, dividend hike, and a passing stress test grade. (Quick quiz, with the answer to be given later: are the banks announcing share buybacks likely to be the strong banks or the weak banks with respect to the stress test? Write down your answer and we’ll come back to it.) Volume on the exchange spiked, with better than 50% of the day’s volume coming in the last hour of trading, and almost 30% in the last 7 minutes before the bell.
The stress test results were released, and four financials failed: Ally Financial, SunTrust, MetLife, and Citigroup. Well, good luck raising capital now, Citi. (Important Disclosure: I am expressing no opinion on any of these individual equities or any of the other securities of these companies. I neither own, nor intend to buy, nor sell, any of their securities in the near future. My negative opinion on banks generally is well-known, but I do not have any position, positive or negative, on the banking sector, nor do I plan to make such a sector bet in the near future).
Now, initially the press coverage listed three of the four firms that failed, but not MetLife, so I was forced to go skimming through the “CCAR” report to find the fourth one. If I hadn’t done that, I almost certainly would not have noticed Figure 7, which is reproduced below for your easy reference.
You can see the four banks which failed are the shortest bars on this chart, so you can easily pick out Ally, Sun Trust, Citi, and with a straightedge you can conclude that MetLife is the fourth. But then it’s a really close race for fifth-worst with KeyCorp, US Bank, Morgan Stanley, and… JP Morgan. It must be great to be JP Morgan. When you wonder why they drew the line where they did, you might imagine the counterfactual situation where JP Morgan came out on the other side of the line. JP Morgan, which was the Fed before there was a Fed, and will probably be the Fed after the Fed is gone. JP Morgan, which the Fed called on multiple times during the crisis to save the world (for example, by serving as a lending conduit to entities which the Fed could not directly lend to). I wonder what the odds are that JP Morgan would be allowed to fail? I’m going to speculate: zero. And that’s why the line is where it is.
Now, it is interesting to see which banks scored very highly. They’re banks that don’t have exposure to as many of the blow-up areas that were tested by the Fed (which is not to say they aren’t exposed to blow-ups: just that they’re not the ones that the Fed tested).
By the way, don’t let anyone tell you “well, this was a really severe test, and so these banks are actually in really good shape.” Yes, this test is much more stringent than the cotton-candy version the European regulators put their banks through last year, but it only measures expected reactions to broad macroeconomic events, and not the interaction of the entire system under such a stressful scenario. That reaction is non-linear, and it is very difficult to model. Moreover, we can’t model the unknown: a rogue trader, a $65billion Ponzi scheme, a tsunami and nuclear meltdown in Japan, a terrorist attack in New York. As Roseanne Roseannadanna used to say, “It’s always something.”
When all is said and done, are we better off that the Fed did these stress tests? I suppose the answer is yes, if only because it means the regulators actually took some interest in looking at these businesses and their risks. But if it creates a false sense of comfort, or reverses the trend towards greater capital cushions, then probably not. Time will tell.
I am about ranted out for today, and there are no important economic releases tomorrow. It will be interesting to see how the spin machines work on Citigroup and JP Morgan, which are after all separated by only a thin line on Figure 7, but by a huge gulf in reputation.