Philip Grant: The credit-lending labyrinth
From Almost Daily Grant’s:
From Wednesday’s edition of the Sacramento Bee:
A fire-gutted house in Silicon Valley has hit the market for $800,000.
While that might seem a tad pricey for an uninhabitable, burned-out hulk, Realtor Holly Barr told KTVU the price reflects the value of the property, not the ruined house currently occupying the lot. The house burned down two years ago.
A post Monday on the Willow Glen Charm page on Facebook lists a $799,000 asking price. Barr told KTVU she’s already received at least 10 offers and expects to sell the property in the next few days.
It’s still early, but 2018 could thus far be termed, the “Year of the Whipsaw.” As the major equity indices dart to and fro in a manner unseen last year, economic signals impart no obvious regime change. Unemployment is low and job growth is slow, while GDP continues to expand at a plodding rate.
Interest rates, as measured by the shape of the yield curve, are moving more decisively. While the benchmark 10-year yield remains below its December 2013 interim highs, the short end has raced higher with the two-year yield jumping above 2.3% to its highest since 2007. That divergence has compressed the spread between the two rates to less than 47 basis points, narrowest since the financial crisis. Customarily, a flat or inverted yield curve signals a market expectation of slower growth ahead.
Barring an abrupt monetary change of course, that spread looks set to narrow further. Longer yields have come down in recent months, yet interest rate futures currently price in 69% odds of at least two more 25 basis point hikes in the overnight Fed Funds rate this year, following such moves in December and March. Interbank lending rates, as measured by Libor (the London interbank offered rate), have risen even more quickly, more than erasing a 30 basis point discount to the two-year Treasury yield at the beginning of the current monetary tightening cycle.
At least one member of the Federal Reserve board is pondering an even faster turn of the short-end screws. In a speech this morning, Boston Fed president Eric Rosengren took note of the tight labor market (headline unemployment came in at just 4.1% in March, matching its post-2000 low) and forecast a further tightening of the labor market and inflation uptick. Rosengren, currently a non-voting member of the Fed, went on to provide his prescription: “Therefore, I expect somewhat more tightening may end up being needed than is currently reflected in the projected median for the federal funds rate.”
Rosengren’s remarks beg the question: What sort of consequences might follow a further rise in short-term rates, particularly in interbank lending? For the domestic money center banks at least, so far, so good. This morning, J.P. Morgan Chase & Co. reported record first quarter net income of $8.7 billion, a 35% jump year-over-year, while Citigroup, Inc. and Wells Fargo & Co. (which is in regulatory purgatory after a series of scandals) reported year-over-year gains in net income of 13% and 5.5%, respectively. According to Bloomberg, the stronger bottom lines are at least partially attributable to higher lending rates:
The largest U.S. lenders could each make at least $1 billion in additional pretax profit in 2018 from a jump in the London interbank offered rate for dollars, based on data disclosed by the companies. That’s because customers who take out loans are forced to pay more as Libor rises while the banks’ own cost of credit has mostly held steady.
“During the 2008 crisis, [rising Libor] was the sign capital markets were frozen,” said Fred Cannon, head of research at Keefe, Bruyette & Woods. “Now there’s all this liquidity, so they don’t need to borrow in the Eurodollar market,” where rates are based on Libor, he said.
Of course, for every lender there’s a borrower, and if some constituencies benefit from a change in credit conditions, others must suffer. Yesterday, a Bloomberg dispatch identified one group of unfortunates: “Default risks are rising for U.S. companies with high leverage and floating-rate debt as Libor jumps.”
While floating rate borrowers’ exposure to a rising Libor is no breaking news, the move is causing pain in far-flung places. Here’s Bloomberg again, this time on Wednesday:
Norwegian households and companies are feeling the sting from policy choices across the Atlantic. Growing U.S. deficits have triggered a deluge in Treasury bill supply, helping drive up the London interbank offered rate and a key dollar-financing indicator that feed directly into the benchmark Norwegian interbank rate.
If the surge continues, banks in the Nordic country may be forced to raise mortgage rates, perhaps giving the central bank pause as it prepares to tighten for the first time in seven years after the summer.
The Land of the Midnight Sun is particularly poorly positioned for rising borrowing costs: The Organization for Economic Co-Operation and Development calculates Norway’s ratio of household debt to disposable income at a towering 230% as of year-end 2016; only the Netherlands (270%) and Denmark (285%) are more encumbered within the OECD’s 34 country data set.
For more on Norway and its debt-heavy and negative-rate-happy Nordic peers, see the Nov. 30, 2017 edition of Almost Daily Grant’s (“Prognosis negative“). For more on the potential impact of rising borrowing costs on the legion of cash flow-negative “zombie companies” which increasingly stalk the business landscape, see the March 23, 2018 edition of Grant’s (“The nine lives of the modern leveraged company”).
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