US banks are scary strong

Good morning. Today, for the first time in a little while, the gilt market has to get by without help from the Bank of England. Some observations — but no predictions — on that situation below. In the US stock market, we will find out what happens after a wild up day (last Thursday) and a wild down day (Friday). An outbreak of calm? We doubt it. Email us: robert.armstrong@ft.com & ethan.wu@ft.com.

The good (that is, bad) news from the big US banks 

A bank cannot perform much better than the economy it operates in. Banks make loans and provide transaction services to businesses and households. They are leveraged, so in an upturn they do a bit better than the economy. But in a downturn, they do a bit worse, so it evens out. If banks try to grow much faster than their economic environment, they blow themselves up, à la 2008.

By the same token, when trying to understand an economy, look at how its big diversified banks are doing. Few businesses provide a better view. Third-quarter earnings for four of the biggest US diversified banks came out last Friday: JPMorgan Chase, Wells Fargo, Citigroup and US Bancorp. What did we learn?

We knew that certain highly interest rate- and market-sensitive businesses were going to be weak, and they were. So, for example, Wells Fargo’s non-interest income was 25 per cent lower than a year ago, as mortgage origination fees fell. A doubling in mortgage rates will do that. Similarly, at JPMorgan, investment banking fees fell by almost half from a year ago, as the IPO and underwriting businesses dried up.

But then there are the core economic signals a bank’s results send off: are people spending? How are deposit balances? Is there demand for commercial and credit card loans? Is anyone defaulting, or paying late? Here the story is very different. The banks reported, in short, that these things are sending no signals of a slowdown whatsoever.

Start with what the banks’ leaders said. An analyst asked JPMorgan execs if they were “beginning to see cracks, either be it commercial, real estate, consumer, where it feels like the economic pain from inflation, higher rates is beginning to filter through to your clients?” 

The CFO answered (italics ours): 

The short answer to that question is just no. We just don’t see anything that you could realistically describe as a crack in any of our actual credit performance . . . We’ve done some fairly detailed analysis about different cohorts and early delinquency bucket entry rates and stuff like that. And we do see, in some cases, some tiny increases. But generally, in almost all cases, we think that’s normalisation, and it’s even slower than we expected

That message was echoed by executives at every bank that reported. Charlie Scharf, CEO of Wells, gave the most detailed overview:

Deposit balances per [retail] account decreased from the second quarter, but were still higher than a year ago and remained above pre-pandemic levels. However, we continue to closely monitor activity by segment for signs of potential stress and for certain cohorts of customers. We’ve seen average balances steadily decline and are now below pre-pandemic levels, and their debit card spend continues to decline . . . but it’s important to note that this remains a small percentage of our total customer base. Overall, our consumer deposit customers’ health indicators, including cash flow, payroll and overdraft trends, are still not showing elevated risk concerns. Debit card spending remained significantly above pre-pandemic levels . . . Credit card spend remained strong in the third quarter, up 25 per cent from a year ago, with double-digit increases coming across all spending categories . . . Period-end commercial loan balances were stable compared to the second quarter, with continued growth in commercial banking, offset by declines across our businesses in corporate and investment banking. Credit performance remained strong.

I had a hard look at the numbers. If there was anything in there that deviates from the execs’ narratives, I missed it. As expected, higher rates and the end of quantitative easing have slowed or in some cases reversed deposit growth, but credit card loans, debit card volumes, commercial loan growth all look sound. Allowances for loan losses and delinquencies are rising with loan balances but are still at or below pre-pandemic levels.

The Fed tightening is having a dramatic effect on financial conditions and markets, as well as the directly rate-sensitive aspects of the US economy such as housing. But that has left a lot of the rest of the economy all but untouched. Unhedged thinks we have seen peak inflation, but the Fed has a lot more work to do to get demand down. It’s going to be a slow grind down.

Gilts

After watching Thursday’s tranquil trading session in UK markets, Unhedged tempted the news gods, writing that the “‘mini-Budget mini-crisis may end with a whimper, not a bang”. Then on Friday, to make us look dumb, Liz Truss fired her chancellor and restored £18bn in corporate tax increases, a fraction of the “mini” Budget’s £43bn in tax cuts. The market reaction was violent: long gilt yields, which had fallen earlier in the day, leapt. Was Truss’s walkback not enough? The market, one analyst told the FT, “was hoping for a lot more”:

The pound fell too, though the move was measured:

The popular narrative is that Truss failed to convince markets on Friday. Is that quite correct? The logic is compelling. Unless Truss performs another volte-face, £25bn in unfunded tax cuts (and a big energy price guarantee) remain in the pipeline. That would feed inflation, possibly forcing the Bank of England into further rate increases. Gilt yields, then, should follow the BoE up.

We’d offer a note of caution: it is still very hard to distil a clear economic message from moves in UK markets. Forced selling from pension funds may not be over. In fact, UK pension funds are hoarding cash in case of new collateral calls. Add to that a contrary data point from Friday: expectations for the BoE’s terminal rate edged down a bit from 5.5 per cent. That hardly seems like fresh inflation panic.

In a note over the weekend, analysts at Goldman Sachs offer one potential explanation for falling rate expectations despite surging gilt yields. Slowing growth, a higher corporate tax and much tighter financial conditions, they say, make inflation look less menacing, and that spells a lower terminal rate:

The persistence of core inflation and the continued tightness in the labour market suggests that the BoE still needs to take monetary policy into significantly contractionary territory. That said, following PM Truss’s policy reversal we think there is less pressure for the BoE to act aggressively in the coming meetings. We now look for 75bp hikes in November and December (from 100 bps previously), followed by a 50bp hike in February and two 25bp hikes in March and May.

Whether Goldman is right, the point is that UK markets are not straightforwardly legible right now. Gilts, we suspect, are getting swirled around by non-fundamental buying and selling. We’ve yet to see what the market looks like since BoE bond-buying ended Friday.

That applies just as well to the idea, disputed in this column last week, that markets are assigning a risk premium to UK assets. Good to discuss, but needs to be understood tentatively. Narratives built while the dust is still in everyone’s eyes could fall apart fast. (Ethan Wu)

Two good threads

Two Twitter threads on the impact of the new US export controls on China’s chip industry. One sees “paralysis” and “annihilation.” The other sees uncertainty and warns against overreaction.