Equity rally led by investors piling into banks: likely wrong move

Investors adding new money to the market and to the bank sector in particular, drive the current rally in US equities. Two reasons: deregulation and higher interest rates. We have discussed the deregulation issue already, creating a longer-term risk to the economy, as investment banks can now play chicken with the Fed all over again, and spreading risk throughout the financial system.

Expectations for higher short-term rates, sooner rather than later, have given another reason to invest in banks. We have seen this cycle many times over the last few years. When the Fed threatens or even delivers rate rises, the bond market does not follow them at first, and banks rally.

Each time since the start of the expansion in 2009, the markets have decided the economy is not ready for active monetary tightening and rate expectations have fallen back. Bank stocks have done likewise. The cycle since the Presidential election is easily the strongest. The largest, most important bank in the world, JP Morgan, is up nearly 50% since Trump.

Currently, it appears there is more life in the idea that rate rises will stick. Markets are pricing in two and a half hikes this year while the Fed projects three. The higher market rates will be aiding bank revenues, no doubt, as the squeeze on the profitability of collecting deposits eases.

However, the rally will most likely peter out, as nominal growth is just not strong enough to absorb any monetary tightening. The opposite will occur and rates will come back down again. The 10yr less 2yr spread did rise post-Trump, but has resolutely not gone even back to the levels of 2015.

Monetary policy, judging by the long-term average in this spread alone, looks neutral at best. All the earlier periods when it was higher than 125 basis points were periods when the US enjoyed much healthier nominal growth rates.


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