Hey.
I'd like to talk about the effect of lower interest rates on something called 'net interest margin'...
In other words, how banks make money.
The chart attached shows US commercial banks' net interest margin (blue) versus the target Fed Funds range (white).
Net interest margin (NIM) is a measure of the difference between the interest income generated by banks or other financial institutions and the amount of interest paid out to their lenders (for example, deposits), relative to the amount of their (interest-earning) assets.
What can we see from the chart?
As the Fed Funds target range decreases, bank net interest margin does as well.
Currently, there is talk of going negative, and just last week, Fed Funds futures priced in negative rates for the first time ever for the Dec 2020 meeting and the Jan 2021 meeting.
This is important.
See, if people are of the opinion that lower interest rates will lead to less bank profitability, then they are likely to short financial stocks.
And if people are shorting financial stocks, it can lead to a decline in lending and liquidity in the economy - which leads to dampened demand.
Over the last few years, a type of bond known as an AT1 (Co-convertible) has been used to try to sure up bank common equity tier 1 (CET1).
This gives regulators a gauge of strength of the financial institution in question.
It works like this...
The investor buys the bond, and if the share price of the bank falls to a certain level, the bond is converted into equity to prop up the CET1 of the bank.
The problem is that these investors (mainly hedgefunds and sophisticated investors), are alpha seeking...
In other words, they will hedge the delta of the decline in their bond by shorting the bank stock.
This creates a bit of a doom loop on two fronts, firstly by removing the validity of the AT1 instrument, but secondly, the decline in net interest margin leading to the shorting of bank stock and the incapability to adequately lend.
Markets and economies function on liquidity, and without it, we are in serious trouble - which explains the lengths to which governments and central banks have gone to liquify *everything*...
And why equities just keep going up...
See lower rates and more QE lead to equity risk premium compression - that is, the premium paid to take the risk of investing into higher risk assets versus simply staying invested in riskless assets (such as government bonds) - and ends up with investors piling money into equity markets.
If the perceived risk of investing into equities is a tiny bit greater than staying invested in risk-free assets, then you will get into equities.
This is exactly what has happened over the last 10 years - and it's why the market threw a fit when the Fed tried to raise back in '18.
Passive long strategies have become the norm - buying ETFs such as $SPY and simply holding - and this also affects bank profitability; less trading = less commissions paid to the dealer.
This is one reason why so many banks have moved into high frequency market making activities - Volcker prevented them from prop trading, but allows for market making (which in the high frequency trading area is largely still prop trading, although trying to prove that is tough).
Jerome Powell is expected to push back against negative rates tomorrow, and the rhetoric leading into this from Fed members has been that they do not like negative rates.
It remains to be seen, but real yields across the curve from 1y-30y are currently priced negative...
So what's the difference, really? (tongue in cheek).
I'd like to talk about the effect of lower interest rates on something called 'net interest margin'...
In other words, how banks make money.
The chart attached shows US commercial banks' net interest margin (blue) versus the target Fed Funds range (white).
Net interest margin (NIM) is a measure of the difference between the interest income generated by banks or other financial institutions and the amount of interest paid out to their lenders (for example, deposits), relative to the amount of their (interest-earning) assets.
What can we see from the chart?
As the Fed Funds target range decreases, bank net interest margin does as well.
Currently, there is talk of going negative, and just last week, Fed Funds futures priced in negative rates for the first time ever for the Dec 2020 meeting and the Jan 2021 meeting.
This is important.
See, if people are of the opinion that lower interest rates will lead to less bank profitability, then they are likely to short financial stocks.
And if people are shorting financial stocks, it can lead to a decline in lending and liquidity in the economy - which leads to dampened demand.
Over the last few years, a type of bond known as an AT1 (Co-convertible) has been used to try to sure up bank common equity tier 1 (CET1).
This gives regulators a gauge of strength of the financial institution in question.
It works like this...
The investor buys the bond, and if the share price of the bank falls to a certain level, the bond is converted into equity to prop up the CET1 of the bank.
The problem is that these investors (mainly hedgefunds and sophisticated investors), are alpha seeking...
In other words, they will hedge the delta of the decline in their bond by shorting the bank stock.
This creates a bit of a doom loop on two fronts, firstly by removing the validity of the AT1 instrument, but secondly, the decline in net interest margin leading to the shorting of bank stock and the incapability to adequately lend.
Markets and economies function on liquidity, and without it, we are in serious trouble - which explains the lengths to which governments and central banks have gone to liquify *everything*...
And why equities just keep going up...
See lower rates and more QE lead to equity risk premium compression - that is, the premium paid to take the risk of investing into higher risk assets versus simply staying invested in riskless assets (such as government bonds) - and ends up with investors piling money into equity markets.
If the perceived risk of investing into equities is a tiny bit greater than staying invested in risk-free assets, then you will get into equities.
This is exactly what has happened over the last 10 years - and it's why the market threw a fit when the Fed tried to raise back in '18.
Passive long strategies have become the norm - buying ETFs such as $SPY and simply holding - and this also affects bank profitability; less trading = less commissions paid to the dealer.
This is one reason why so many banks have moved into high frequency market making activities - Volcker prevented them from prop trading, but allows for market making (which in the high frequency trading area is largely still prop trading, although trying to prove that is tough).
Jerome Powell is expected to push back against negative rates tomorrow, and the rhetoric leading into this from Fed members has been that they do not like negative rates.
It remains to be seen, but real yields across the curve from 1y-30y are currently priced negative...
So what's the difference, really? (tongue in cheek).
FREE 100+ page bond trading guide! pro.fink.money/subscribe
$XLF is down 1.10% on open.