Germany continued to reduce interest rates in August to a negative 0.9% for the 2-year Bund and negative 0.75% for the 10-year Bund. The result of negative rates is a stronger US dollar, rising 8.8% from the lows of 2018.
A strong dollar limits US exports, contracts multinational corporations profit margins, reduces valuations of emerging markets and lowers prices of commodities, such as oil and copper. More importantly, a strong trade-weighted dollar, currently 92.4, rising substantially above 96 (a new high) would reduce US exports, weaken US employment and slow consumer spending. To combat dollar strength, the Federal Reserve is expected to reduce the Fed Funds Rate from over 2% to 1.5% or less.
Solving the dilemma of negative interest rates and Germany’s export problem is more complicated. Brexit must be resolved between the UK and Europe, and the China-U.S. trade disputes settled. Then hopefully German interest rates will become less negative and the 10-Year Bund will return to positive levels.
Unfortunately, the China-US trade dispute appears to be in limbo until after the 2020 US election. Brexit continues to be delayed and appears to be at an impasse, indicating the likelihood of a no-deal Brexit. A reaction to the Federal Reserve to reduce the Fed Funds rate by 50 basis points or more could well ignite inflation. As in the past, the lows in US yields and the peak in the US dollar, like stock price lows, occur at the same time as the “negatives” are most pronounced in media and public opinion.
ROE vs. COE is the Best Indicator of Bank Stock Value
IDC Financial Publishing (IDCFP) measures relative profitability of bank holding companies by comparing the IDCFP return on tangible equity (NOPAT ROE) to our definition of the cost of equity (COE). Margin between ROE and COE (included in the “M” in IDCFP’s unique CAMEL analysis) is a key measure of management. If the spread of ROE less COE is positive, or improving, management is creating value; the wider the spread, the greater the value.
If the spread of ROE less COE is decreasing, or negative, management is destroying value. Bank value, in turn, is then determined by comparing its stock price to its tangible book value, i.e. equity market capitalization to tangible book value of common stock, versus the spread between ROE and COE to determine a bank’s valuation (see Chart I).
There has been a sharp decline in the US 10-Year T-Note yield from 3.22% to 1.6% currently. This was a result of the US 10-Year yield reacting to a collapse of the German 10-Year yield from a positive 0.6% to a negative 0.7% in August 2019. Bank ROEs are limited by declining long term yields, reducing interest income from loans. The high level of the federal funds rate and, therefore deposit costs, further reduces bank profit margins. Bank stock valuations, therefore, fell 10% from 2019 highs and are selling 25% below normal valuations.
Another impact of the high short-term interest rates relative to US Treasury yields is the dramatically slowed growth of brokered CDs outstanding. After strong quarterly increases in 2018 and 2019, brokered CDs fell 7 billion, from $433 on June 30th to $426 billion on July 31st. Over the same period, the number of institutions issuing brokered CDs also fell from 1366 to 1349. Given the drop in lending rates due to lower treasury yields, banks are limited in the amounts they pay on deposits.
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John E Rickmeier, CFA, President, email@example.com
Robin Rickmeier, Marketing Director