Is it safe to own long bonds again?

Good morning. What do you do when your fund’s annualised three-year return is minus 28 per cent? You tout the tax advantages of the huge losses: “I don’t think many people understand what an asset we have in terms of those tax-loss carry-forwards,” says Cathie Wood, who runs the Ark innovation ETF. If you, too, are seeing the bright side in dark times, by all means email me: robert.armstrong@ft.com

The long end looks (a little bit) better

Last week the 10-year Treasury yield rose 29 basis points, which is a lot. Eight more basis points and the ten year hits the symbolic threshold of 5 per cent. This column has banged on about the appeal of the short end of the curve quite a bit, but at some point, you have to ask whether it is time to take on some duration

We last raised this question back in July, and concluded that “adding a little duration makes sense,” but that the middle of the curve was more appealing than the long end. Too much disinflation and too many rate cuts were already priced in, as evidenced by (among other things) a very inverted curve. I am glad I wasn’t bolder then. The Bloomberg ten-year total return bond index has fallen 17 per cent since, while the 5-year index is only down marginally.

It is precisely those long-bond losses that suggest it is time to take another look at duration. Summing up the current picture, the list of positives looks something like this:

• We do not know if the Fed is finished cutting rates. But we can be fairly confident that we are near the end. Near the end of a rate cycle is historically a pretty good time to own bonds.

• Real Treasury yields are significantly positive on most measures of current inflation.

• The curve is less inverted now, suggesting less confidence about lower rates is already priced in to the long end. There is more room, in other words, for a positive surprise.

• 10-year inflation break-evens are up, too — another indicator of realistic expectations. 

• High long-term interest rates will themselves slow the economy and keep the Fed from raising rates too aggressively (the thirty-year mortgage rate hit 8 per cent last week!).

The negatives run as follows:

• The Fed might not be done. Economic growth continues to surprise to the upside, and historically, inflation does not decline smoothly.

• Cash pays more than 5 per cent. You can collect that with little duration risk, and if something awful happens to bring rates down, you can redeploy capital to risk assets, which will have fallen too.

• The term premium is high right now. If you think the term premium is rubbish, or just mysterious, why not wait until it is lower to leap in to the long end?

• We have good reason to suspect that the long term natural rate of interest is getting higher (fiscal excess, changing demographics, and so on). Just because 5 per cent looks high by the standards of the last ten years does not make it high by the standards of the next 10.  

Where is the balance between pro and con? My inclination is that it is impossible to call exactly where we are in the tightening cycle. Short term volatility in long bonds looks inevitable to me. Looking to the longer term, though, it seems unlikely the secular trend in interest rates has changed so much that ten-year Treasuries bought at a five year yield will incur severe, lasting losses. For the first time in a while, adding a little exposure at the long end of the curve, thereby locking in current rates, makes sense to me.

My confidence in this call is, as ever, quite low, and I am sure Unhedged readers know better. Email me. 

Bank margins are just not that bad

The performance of bank stocks since March of this year has been absolutely horrific:

The reason bank stocks crashed in March was the collapse of Silicon Valley Bank and, following that, of First Republic. But those banks’ problems — very, very bad interest rate risk management — turned out to be shared by very few other banks. The industry has chugged along reporting OK earnings in the months since. Furthermore, economic growth has been consistently better than expected, and banks are economically sensitive.

Why, then, have the stocks not recovered? Two big reasons. One is the view that short term interest rates will be higher for longer, and this will hurt bank margins. The other is the view that high long-term interest rates will eventually cause serious credit problems for banks, starting with commercial real estate lending.

I suspect that the first reason, which was the focus of much of the comment on bank earnings reports that rolled in last week, is overblown. Yes, bank executives did warn that deposit prices, which have been rising, will probably continue to do so through the end of the year and into early 2024. But this will not be an unalloyed drag on earnings for all banks, and there is reason to believe that the worst of the margin pain is over. 

By way of example, here is the trend in the cost of interest-bearing deposits for four megabanks and one large regional, Regions Financial:

There is an old and persistent idea that banks borrow money at the short end and lend money at the long end. If that’s true, then the fact that short rates have risen more than long rates in the past few years should directly translate to lower bank margins. But it’s not true: banks mostly borrow at the short rate, and lend at the short rate plus a fixed spread. So higher short rates can help or harm a bank’s margins, depending on the totality of that bank’s exposures on both the asset and liability sides of the balance sheet. Here is the interest rate spread (the average rate earned on assets minus the average rate earned on liabilities) of those same banks over the same period:  

The most recent trend is down, but note that three of the four banks have higher spreads now than they did when rates were at zero. The fourth, Bank of America, has a lower spread primarily because of issues on the asset side of the balance sheet, not because of deposits (I have used net interest spread here, not net interest margin, because the latter also reflects changes in overall leverage and I wanted to focus on rates alone). 

On the trend in spreads, the question is how much deposit rates still have to rise in response to higher short rates. This happens at a lag, whereas asset returns adjust almost instantly, which is why spreads rose at first and are now falling. It is notable that at all of the banks except Regions, the rate at which deposit costs are rising slowed in the third quarter. For big banks especially, most of the commercial and household deposits that remain may be operational accounts, rather than a meaningful source of yield for their owners. If so, banks may be over the hump, profits-wise. As Chris Kotowski, banking analyst at Oppenheimer, told the FT recently: 

The real savings in our society have left the banking system long ago. The real savings in our society are mainly in brokerage accounts and mutual fund accounts . . . The dollar average amount in the average bank account in the country, the retail account. is about $43,000. But the median is about $5,000 . . . that’s a family that’s probably earning $60, $70 $80,000 a year and they had $3 or $3,000 or $5,000 a month coming in on direct deposit, and they’ve got $3,000 or $5,000 a month going out on bill pay and cash withdrawals and checks. even though it may be technically called a savings account, for the most part, those things are not savings accounts

Banks stocks overall are not down as badly as they are because of margin compression. They are down because the events of March scared investors to death, and they have not gotten over it.

The question of credit risk remains. As Gerard Cassidy of RBC pointed out to me, most banks are not crushed by rate risk (that is precisely why the failures of March were so anomalous). They are crushed by loans going wrong. And it is possible that high rates, if paired with a slowing economy, could cause a default wave in the months to come. That’s a risk bank investors need to price in. But if you are betting on a soft landing, banks are an increasingly interesting way to express that conviction. 

One good read

A report card for the Belt and Road Initiative