Rough Waters Ahead for Banking Sector?
Global Financials Analyst and Portfolio Manager Barrington Pitt Miller discusses why rising interest rates, an end to loose monetary policy and a healthy economy all bode well for global banks. Yet, those exposed to short-term funding markets may face risks related to U.S. Treasury bill issuance and repatriation of cash by U.S. corporations.
- Rising interest rates in the U.S. and a move away from quantitative easing abroad bode well for global bank profitability
- A wave of U.S. Treasurys issuance may entice money market funds to favor Treasurys over commercial paper, a popular source of funding for many banks
- Repatriation of foreign earnings by U.S. corporations has the potential to reduce the supply of U.S. dollars lent by foreign banks
Investors are divining how recent shifts in the policy landscape may affect financial markets. Rising interest rates in the U.S. and the potential end of quantitative easing (QE) in Europe should soon aid bank profitability in the form of higher net interest margins (NIM). For this reason – along with generally positive trends in the global economy – we have a favorable view toward the global banking sector. Yet, ramifications stemming from the U.S. budget deal, tax reform and changes in global monetary policy could negatively impact certain banks, especially those reliant on short-term lending markets.
A Flood of T-Bill Issuance
We believe that the recent U.S. budget deal along with certain components of the tax package will soon cause an increase of T-bill issuance, or securities with maturities under one year. While the market is pricing rate hikes into T-bills, we believe that it has yet to fully appreciate the downward pressure on prices that a wave of issuance would cause, especially given the current low base.
Higher yields on T-bills would likely incentivize money market funds to raise their allocation to government securities at the expense of commercial paper (CP), a popular source of short-term funding for many banks. A decrease in demand for CP would raise some institutions’ borrowing costs and, in part, be reflected in a higher London Interbank Offer Rate (LIBOR). As LIBOR serves as a benchmark for a wide range of credit products, a higher rate runs the risk of suppressing demand from borrowers, while simultaneously diminishing some of the benefit of higher net interest margins for those more CP-dependent banks.
Two additional factors that may impact the yield on T-bills, and thus their relationship with CP, are seasonality and inflation. Typically, T-bill issuance decreases in the second quarter as tax receipts replenish federal coffers. While we expect this to occur, we are keen to see whether the trend toward higher issuance resumes in the third quarter. We must also be aware of an increase in the pace of inflation. Should higher inflation lead to an increased cadence of interest rate hikes, the accompanying higher yields on T-bills would further enhance their attractiveness vis-à-vis CP.
Timing magnifies this risk as the negative interest rates that have pushed European and Japanese investors toward U.S. Treasurys may be getting long in the tooth. Driving European rates negative – and the region’s investors to the U.S. – are European Central Bank (ECB) purchases that are presently many multiples higher than net bond issuance. With the end of QE in sight in Europe and Japan undergoing a “stealth taper,” diminishing international demand for Treasurys would only push T-bill yields higher and possibly accelerate money market funds’ rotation away from bank CP. We started seeing evidence of these imbalances early last year in the form of deteriorating demand for T-bills as measured by bid-to-cover ratios in Treasury auctions. This ratio, which recently reached a decade low, reflects the level of bids in an auction per unit of T-bills on offer.
Already there are indications that segments of the U.S. fixed income market are experiencing a reversal of flows. Net foreign purchases of U.S. corporate bonds recently turned negative after having enjoyed robust inflows during the ECB’s era of QE. And this is when interest rate differentials between the U.S. and the rest of the developed world would infer continued demand for U.S. assets. Pressure may already be appearing in the interbank-lending market. The spread between the 3-month U.S. dollar LIBOR and more-liquid overnight interest rate swaps (OIS) has recently reached its highest level since the European Sovereign Debt Crisis.
Eurodollars Heading Home
Another policy shift that may prove negative for international banks is the greater ease in which U.S. corporations can repatriate foreign earnings. U.S. companies at present hold roughly $3 trillion in foreign bank accounts. These deposits are a captive source of funding for U.S. dollar-denominated loans issued by foreign banks – known as eurodollar loans – and are likely one reason behind the rise in the global share of dollar-denominated lending emanating from foreign shores over the past decade. We believe that the repatriation of even a portion of the $3 trillion held overseas by U.S. companies has the potential to disrupt the eurodollar system.
Fewer dollars abroad could result in less foreign interbank lending, possibly placing upward pressure among LIBOR. Should this occur, the resulting environment would be more favorable for banks with a natural U.S. dollar funding base, rather than those reliant upon short-term dollar markets. For the latter group, repatriation – as is the case with T-bill issuance – could act as another speed bump in an otherwise conducive environment for global lenders.
Short-Term Lending Markets Flashing Caution Signs for Certain Banks?
CDS Spread Reflecting Pressure on Certain Banks?
The converging forces of T-bill issuance and dollar repatriation may, in part, be behind the recent spike in the spreads of investment-grade credit default swaps (CDS). Some of the recent widening of CDS spreads was likely due to market volatility. Concern, however, that widening CDS spreads are signaling the later stages of the credit cycle may be premature. Undeniably, rising funding costs can play into that thesis. At this stage, we believe context is paramount given that spreads are so low thanks to QE-induced market distortions. We view the recent spike not as a final gasp of an extended credit cycle, but more as another step toward policy and market normalization.
Still, how T-bills and the eurodollar market react to changes in monetary and fiscal policy merit close scrutiny given reliance banks have on short-term borrowing.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.
U.S. Treasury securities are direct debt obligations issued by the U.S. Government. With government bonds, the investor is a creditor of the government. Treasury Bills and U.S. Government Bonds are guaranteed by the full faith and credit of the United States government, are generally considered to be free of credit risk and typically carry lower yields than other securities.