In order to make money, Starbucks has little choice but to sell coffee. Ford must sell cars if it hopes to stay open. And Lockheed Martin better get orders for bombs, missiles and planes if it is to remain relevant. But banks do not need to make loans (their stated purpose) in order to make payrolls and pay shareholders a dividend, at least at certain points in the cycle. When the yield curve is steep, banks can borrow money cheaply at the central bank, and buy longer dated government bonds (that do not need to be marked-to-market on their books) and thereby capture “free-carry” (ask Japanese banks; that’s pretty much all they have done for the past twenty five years!). In this respect, banks are genuinely a unique type of business in our economic systems: they are the only business that can make money “for free” on the back of “government benevolence”.
Of course, this government benevolence is not always there: yield curves can flatten, or even invert, resulting in the free money punch-bowl being taken away. And, the yield curve can move into negative territory, with equally detrimental effects on banks’ income statements.
Which brings us back to a point we have made repeatedly in recent months when discussing negative interest rate policies (see The Sum Of All Fears), namely, that bank-shareholders have historically benefited from a central bank “put”. When the time came for bank managements to realize losses and take a hit on their balance sheets, shareholders could always count on the central bank to collapse interest rates. In time, a steep yield curve would let the loss-recognizing banks make “free money”, and so repair damaged balance sheets.
With NIRP the central bank “put” is no more
That was then. Today things are very different. The adoption of NIRP in many OECD markets, and the consequent downshift of yield curves into negative territory, has removed the ability of banks to mend broken balance sheets by playing the yield curve. This means that the next time banks must acknowledge assets gone bad, the losses will be borne fully by shareholders; the central bank “put” will not be available. In turn, this means that the next time banks run into serious trouble, the only options available to governments will be to either nationalize the said institutions (perhaps explaining why bank share prices have lately shown high beta on the downside, and low beta on the upside!) or let them go under (an unlikely policy choice following the Lehman Brothers debacle).
Of course, this is not true everywhere. After all, there are markets today where yield curves and interest rates are positive. In the chart below, we map the difference between ten-year yields and one-year yields in the world’s major markets. Countries with negative one-year interest rates are in red and countries with positive one-year rates in blue:
What is clear is that in 16 out of the 27 countries shown above, the yield curve is now so flat that banks cannot hope to make even as much as 1% by playing the difference between the ten-year and the one-year. With so little “free money” on offer, banks face a tough environment (on top of more costly regulation, the disintermediation from fin-tech and fee pressure). And unsurprisingly the ability to make money, or not, on the yield curve turns out to be a key driver of bank share performance. In the chart below, we show two market-cap weighted bank indices. The first (in blue) is made up of banks domiciled in countries where ten year yields are at least 1% above 12 month yields. The second (in red) comprises banks operating in countries with negative rates or flattish/inverted yield curves.
The index composed of banks operating in a positive rate environment with a steepish yield curve is up 8.7% YTD. By contrast, the banks operating in a negative rate environment with flattish yield curves are down for the year. Notably, the divergence in these indices picked up after the Bank of Japan’s January 29 move to adopt negative rates. So given the clear evidence of negative interest rates hurting the banks, the next question is: why did policymakers sent us down this particular rabbit hole? Will Denyer offered some useful thoughts on this issue in a February piece (see No More Yield Curve To Roll Down). For our part, we see two principal explanations:
Option #1: Negative rates were a mistake
In our view, and given all the conversations we have had with policymakers, this remains the most likely explanation. After all, whenever large foul-ups occur with government policies, Occam’s Razor would point to incompetence (rather than dark conspiracy) as the likeliest explanation. In this case, it seems obvious that given the lackluster growth environment, policymakers felt that “something had to be done”. Negative interest rates were “something” and thus we got negative rates. Perhaps the reasoning did not got much beyond that.
Option #2: Negative rates are a tool to bring banks to heel
It is no secret that the broader popularity of bankers has hit lows not seen since Shylock insisted on receiving his pound of flesh from Antonio. And as the general population’s anger against bankers has swelled, it has lately swept away more than one politician; think of the rise of Donald Trump or Bernie Sanders, the UK Independence Party’s surge or that of the National Front or Alternative For Germany. It is easy to imagine that most policymakers are today rather bitter towards bankers and thinking: “$%@& bankers! They told us we could deregulate the financial industry and that the only consequence would be more widespread growth. Then, they blow themselves up and because we have to bail them out, everyone not only hates them, but us as well! Not only that, but when we give them a steep yield curve to recapitalize themselves, all they do is pay themselves large bonuses!...” Of course, this is not to endorse the above logic; simply to say that among policymakers who are today under fire for cozying up to “Wall Street” or “the City”, the bitterness towards bankers may be deep. And what better way to ensure that bankers stop paying themselves large bonuses, and remain at your beck and call, than to ensure that the free money flows dry up?
Of course, it could be argued that this is a pedantic debate; whether banks are now unable to make money because of policy incompetence, or policy design, at the end of the day matters little to their shareholders. What is important is that banks operating in countries with NIRP now have significant structural headwinds to confront. And so with that in mind, it probably makes sense to own financials only in the countries (on the first chart) where yield curves are steeper than 1%. They should continue to outperform banks elsewhere as any rally in the share price of banks operating in NIRP countries is unlikely to last long.