Bond yields point to a nasty road ahead for the banks

With the second-quarter reporting season underway in the US, this week will see the first round of big bank results. There is going to be acute interest in, not so much what they have earned as what they say.

With JP Morgan Chase, Citigroup and Wells Fargo due to report, the commentary from the first two in particular will be important, given they are among the most global of the US banks and both have big operations and exposures in London.

The focus won’t just be on their assessments of the implications for their businesses in the UK and Europe of “Brexit”, but rather the way that vote has overlaid and further flattened already flat yield curves around the globe.

It might appear odd — it is odd — that even as US equity markets are hitting record levels, yields on bonds of any duration are negligible.

There’s been a lot of focus on what that might mean for the UK and, more particularly, European banks short on capital and long on non-performing loans, but the worldwide flattening of yield curves is a development with global implications for banks.

As discussed previously, when central banks set official rates at close to, or in some cases below, zero it sucks profitability from the banking sector.

Banks have both discretionary funds and regulatory liquidity holdings that are parked with their central banks, generating little or no income or, in the case of some European banks, costing them money.

In the post-financial crisis era of unconventional monetary policies and relatively low levels of demand for credit from risk-averse borrowers, that erodes their net interest margins. There are an estimated $US10 trillion or so of bonds generating negative yields.

Europe and Japan are still pursuing unconventional policies. The European Central Bank has been buying sovereign and corporate bonds and asset-backed securities at a rate that has averaged about €80 billion (about $117bn) a month over the past year. The Bank of Japan has been buying between eight and 12 trillion yen (about $103bn to $155bn) worth of bonds a month.

Those large-scale programs inevitably impact the availability of securities — and their price — for other forced buyers, which include not just the banks but insurers and pension funds that face either regulatory or asset and liability-matching pressures to hold low-risk and long-term financial assets.

Where the low and flat yield curves might conventionally be signalling something quite nasty in the years — indeed decades — ahead, the unprecedented interventions of the major central banks make interpreting the signals quite difficult.

What historically low long-term bond yields do influence is share prices. The meagre yields are forcing those investors with discretion into equities in search of positive yields and returns, creating a novel situation where both bond and equity prices have been rising simultaneously. (As bond prices are bid up their yields fall.)

It is noteworthy that the Australian dollar (traditionally regarded as a risk currency) has performed strongly in the past six weeks even as Australian government bonds yields plumb record-low levels. That’s because those yields still look attractive relative to sovereign bond yields elsewhere.

The central bank interventions haven’t generated much growth or the inflation they seek to ignite — indeed, if one looked at 10-year bond yields in the major economies they are signalling no meaningful levels of inflation for a decade or more.

We may now be moving into territory (we might be there already) where policies that are designed to ignite growth by coercing banks into lending may, by shrinking bank net interest margins, be reducing the capacity of the bank channel to lend.

If banks — particularly the European banks with poor asset quality — aren’t able to generate profits and organic capital to shore up their balance sheets their only alternative is to shrink those balance sheets and improve their capital ratios by lending less.

In the aftermath of the Brexit vote and the uncertainties and risks it has generated, the UK and European banking systems, and those banks exposed to them, also face the prospect of further declines in economic activity and lending and potentially further increases in non-performing loans.

(National Australia Bank’s Andrew Thorburn will be patting himself on the back for demerging Clydesdale, and ending NAB’s long-standing and unhappy exposure to the UK early this year, well ahead of the Brexit vote).

The US banks are operating in an economy with better settings than the UK, Europe or Japan and with a central bank that, while keeping official rates near zero, at least has halted its bond-buying program.

But with other central banks, banks, pension funds and safe haven investors still pouring into the US bond market in search of any positive and risk-free returns, the US domestic banks will still be sideswiped by the impact of the global bond markets’ settings while those with global exposures — particularly those exposed to the UK and Europe — face an extra dimension of earnings pressure and risk.

It is unclear how the breakdown in the conventional relationships between bond and equities markets will eventually be resolved, nor how the big central banks will be able to extricate themselves from the legacies of their post-crisis policies without generating another, different set of the unintended and potentially quite destabilising consequences that are evident in markets today.