Are US banks probably safe from a capital crisis?

Outlook:

It turns out we don’t need China to shock (or blunder) and set off panic. The West can do it all by itself. The Deutsche Bank episode is instructive: the 30% drop in share price so far this year was based on fears of capital inadequacy and took the form of crashing prices for a hybrid “capital” backstop, the infamous coco. Instead of fixing the perceived capital inadequacy, the bank said it would buy back shares. The market bought it, as least for the time being. Are you listening, China? Equity traders can be distracted by shiny things and there is nothing shinier than a stock buy-back.

Remember the fact from Market News last December—of the 24 major world banks with non-performing loans of at least 5% of assets, 21 are in Europe. To be fair, we don’t have the equivalent number for China and our faith in the US capital-building exercise has to go through another annual stress test. In July the Fed demanded $200 billion more capital for eight of the big US banks, and we know the new stress test will contain a worst-case scenario worse than before, including negative yields. The stress conditions were announced Jan 28 but we can’t find the date when results are due, presumably March again. A year ago in March all the banks passed (just).

Does it matter to the stock market that US banks are probably safe from a capital crisis while European banks are not? We won’t know until the crunch comes, if it comes. This is another instance where good news doesn’t drive a market and bad news can be twisted to the detriment of the “good” party. In other words, those who specialize in investing in the financial sector should, perhaps, be siphoning money away from European banks and into US banks, but the rising euro takes away any urgency. This is not to say US banks are “good.” Every time you turn around one or another is being fined hundreds of millions of dollars for past transgressions, including some that are getting pretty long in the tooth. It’s not accurate to say US bank regulation is even remotely good enough, even if capital adequacy might be better than Europe’s.

Moving forward, today is the day Yellen gives testimony to Congress and all eyes will be on her prepared remarks. Yesterday she got another arrow in her quiver—the JOLTS report showed that job openings rose by 261,000 to a seasonally adjusted 5.61 million in Dec—the second best since the report was begun in 2001. Reuters reports “The increase lifted the jobs openings rate to 3.8 percent from 3.6 percent in November. The hiring rate was unchanged at 3.7 percent, indicating that employers were having trouble finding qualified workers for vacant positions.”

Even better, “A total of 3.1 million Americans quit their jobs in December, the highest number since December 2006. That pushed the quits rate, which the Fed looks at as a measure of confidence in the jobs market, to 2.1 percent — the highest level since April 2008…. [And] the number of unemployed job seekers per open job, a measure of labor market slack, fell to 1.4 in December, the lowest level since March 2007 and down from 1.5 in November.” Small businesses in particular report a shortage of qualified workers, perhaps leading to pay rises. We would need another 1%--to 3.5%--for the effect to feed through to headline inflation.

So here’s what Yellen may say, echoing economist Joe Naroff: “If the labor market is tightening, can the economy really be faltering?”

It’s the key question and should silence many a nay-sayer. But other surveys about the probability of recession, ranging from 17-20%, have not done the trick. Worries about a recession remain. Most of all, the FX market, taking its lead from the fixed income gang, has a two-pronged majority viewpoint—that the Fed is not sure enough about one metric, jobs, to justify its December four-hikes scenario, and even if it is willing to base a still-hiking stance on that one thing, global market turmoil will stay its hand.

Last September, we opined that the Fed deferring the first rate hike because of global market turmoil was an unforced error of the worst sort. It put China in charge of US monetary policy. The response was swift and awful. The euro spiked from 1.0941 at the beginning of August to 1.1714 by 8/24 (when China devalued), and after the Fed announcement of delay, tanked from 1.1460 on Sept 18 to 1.1105 a week later. It’s always possible that the Fed in general and Yellen in particular are seeking this exact outcome, i.e., devaluing the dollar. But it’s doubtful, because at the same time, the Fed is devaluing its reputation. Besides, taking monetary policy actions deliberately and specifically to affect the currency level is contrary to the G7 agreement.

We expect the FX market to go sideways and range-trade for a while, as panic settles down to a dull roar. Two things: panic cannot be sustained for long, especially when its causes stop being New. Oil, for example. BBH’s Chandler reports today’s inventory report is expected to show a rise by about 3 million barrels after 7.8 million the week before, the Bloomberg numbers. “Over the past 26 weeks, the US crude inventories have risen by an average of 1.825 mln barrels a week (for a total of 47.45 mln barrels). Over the past 52 weeks, the inventory increase has averaged 1.724 mln barrels a week (for a total 89.65 mln barrels).”

Bottom line, inventories are rising, not falling, implying oversupply. What else do we need to know? Somebody started a rumor that Iran would hold talks with Saudi Arabia about cutting production. This makes no sense in any context. The oil market is more than a little crazy. It’s getting to be time to stop being shocked by oil price gyrations based on nothing much at all when we know, for sure, the real supply/demand situation.

Secondly, FX traders are now in a pickle. Fundamentalist are thrown for a loop by the euro being treated as a safe-haven when it so clearly is not—negative yields and a=n ailing financial sector—and technical analysts are flummoxed by the chart action. As noted above, it’s clear that yesterday’s upward surge came at a point not signaled by any of the standard technical indicators. Choppiness in other currencies also pointed to something else going on, namely algo trading. We can get choppiness without these toxic pests, of course, but every once in a while, you can smell them.

Yellen’s remarks will be released at 8:30 am ET and she is supposed to start speaking at 10 am. We fully expect some fireworks on the euro chart depending on how the remarks play out. If Yellen is optimistic, using jobs as the centerpiece, the dollar can go up. But the minute she speaks of global market turmoil or some variant of that phrase, it will go down. Now is not a good time to be taking positions unless you have deep pockets that can withstand spikes.

Political Tidbit: The world is watching as Trump came in first in the New Hampshire primary, followed by the sane and reasonable, if charmless, Kasich. Fact-checkers are discouraged that they disclose Trump’s lies, but voters disregard them and prefer Trump anyway. This is why we need such a long campaign process compared to other countries—the “low-information” voter (the new euphemism for stupid) takes a while to have his mind changed or to scare the smarter ones out to the voting booth. The Guardian writes “Received wisdom would say that no politician can breezily promise the earth, offering no details, without being dismissed as a charlatan. But Trump’s brazenness on this score is breath-taking.”

Unlike Trump, Bernie Sanders actually does have a policy initiatives. He won New Hampshire, of course, and never mind that free medical care and free college for everyone would cost so much that the US would have to cut the military back to the size of Denmark’s. Both Trump and Sanders are deranged, albeit in different ways. If both win the nomination, we will get Bloomberg entering the race. Won’t that be fun?

“Tis a pity not a single candidate on either side can be called a fiscal conservative. Kasich probably comes the closest but he is not featuring fiscal conservatism (so far). In a way, Trumps’ ascendance is a blow to the Tea Party, which started out wanting smaller government and lower debt but got hijacked by the social issues righties (anti-women, anti-gay, etc.). It is very offensive for Rubio to say he wants to “take back our country.” From whom? A black guy who was elected, twice? From women? Women hardly run The Establishment (although they couldn’t do a worse job). Notice that nobody is ranting about taking back our country from Cuban immigrants—like Rubio (and Cruz). This is the context in which Bloomberg would be a relief.