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Inside Markets — Signal from Banks

Signal from Banks

March 9, 2023

In a clear signal from banks, US large cap and regional bank indices are down ~10% for the week after cautious management presentations at a sell-side conference on Monday.  Takeaways were mostly focused on the likelihood of lower Net Interest Income (NII) as banks begin to compete for deposits. NII is simply the spread banks earn from borrowing short and lending long. Deposits are considered as a liability on a bank’s balance sheet because depositors are paid interest, while loans are considered an asset because they earn the bank interest. Bank deposits ballooned during the Fed’s QE operation and are now shrinking with QT. Banks can only make loans if they have the required amount of deposits and have begun paying higher interest rates to attract more deposits. A macro backdrop that includes a potential recession has the Fed issuing stricter stress test rules, which means higher loan loss provisions, fewer loans and lower earnings. It’s important to remember that banks are the Fed’s transmission mechanism to the economy. And a bank’s business model is the Fed’s main valve when it wants to slow the pace of inflation. This week’s steep decline in bank stocks isn’t a good sign for the economy and has the potential to kick off a ‘bad news is bad’ phase for the broader equity market. Equity and fixed income markets have had a positive correlation since the Fed signaled its tightening cycle in October ’21. Over longer periods of time, bonds and stocks have a negative correlation. A ‘bad news is bad’ phase would resume the negative correlation between stocks and bonds. This means that negative economic data would result in lower bond yields and lower equity prices.  

The S&P 500 (SPX) is currently testing several systematic sell triggers in the mid-3900s.  Closing levels in the low-3900s could generate as much as $50B of incremental selling volume from CTAs and other systematic funds.

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