October 7, 2024 | Updated | The term “jump the shark” dates back to 1985 and the sitcom “Happy Days.” The character Fonzie jumps over a live shark while water-skiing. The idiom "jumping the shark" or "jump the shark,” according to Google AI, means “a creative work or entity has reached a point where something stops becoming more popular or starts to decrease in quality.”
Federal Reserve Board Chairman Jerome Powell seems to have jumped the shark and hard landed, spending a lot of credibility in the process. But we keep wondering: What sudden exigency made Chairman Powell and other FOMC members ignore the mixed economic data and go “all in” on a 50 bp rate cut in September?
Was the Powell FOMC playing election year politics, like all Fed chairs do, or looking at mounting economic woes and deflation overseas? Hard to say. Former Treasury Secretary Lawrence Summers added to the holiday cheer when he said that the 50 basis point interest rate cut last month by the FOMC was “a mistake.” Subsequent domestic jobs data supports this view, however, and suggest that Powell’s latest error may stoke inflation. How could the Fed get things so wrong?
“Every piece of Friday’s BLS report screamed that the Federal Reserve Chairman had jumped the gun yet again in suggesting in his speech on September 18 that the Federal Open Market Committee had shifted its focus from prices to jobs,” writes Komal Sri-Kumar on Substack. "The inflation question is not resolved, and the employment picture remains strong, thank you!"
It is certainly true that the bottom quartile of the US economy is living in extremis, but this is mostly the result of consumer price inflation rather than a slack economy. Housing inflation is a huge pain point for low income households, one reason why we think VP Kamala Harris will lose in November. Inflation and immigration remain the two key issues in this election.
Powell’s shift in focus from prices to jobs we view as election year rhetoric, yet the slowing in the global economy seems to have also figured in Fed thinking. Watching the signs of mounting economic distress in China’s property sector, for example, we remind readers that not only are China’s paramount leaders just as incompetent as our own, but they like to “go big” in ways that would make even the spendthrifts on the Federal Reserve Board red with envy.
China is drowning in a sea of bad debt and even worse economic misallocation. In a sign of desperation, Beijing is throwing hundreds of billions in new cash at a housing economy that is caught in a 1930s style debt deflation. The scope of the value destruction is so great that Chinese consumers are fleeing paper and real estate for gold, contributing to record purchases of the metal.
After a decade of economic growth directed from above, Xi Jinping's “great leap forward" via encouraging domestic real estate development has resulted in a widening financial disaster for private companies and the government alike. Has Irving Fisher’s 1933 essay on debt deflation been translated into Mandarin?
In the US, the situation involving commercial real estate is likewise dire and, as we told our readers months ago, is unlikely to be helped much by lower interest rates. This assumes, of course, that interest rates are moving lower. Blackstone (BX) president Jonathan Gray said in a remarkable front-page story on Friday in the FT that “an accelerating recovery in most of the commercial property market would not be enough to save some over-indebted owners from having to take losses, mainly on offices.”
Thank you so much Jonathan.
The fact that the US economy is racing ahead even as Europe and Asia sink into the mud of economic stagnation speaks volumes about the rules of the dollar system. Americans benefit from higher levels of nominal economic growth due to the massive excess liquidity in the system, but lose ground in terms of inflation and exploding public debt. When you hear people speak about creating “value” in such an environment, just assume it is not inflation-adjusted.
One example of a new definition for value creation comes via the Chief Executive Officer of Italian bank UniCredit (UCG), Andrea Orcel, who quietly built up a 21% stake in moribund Commerzbank AG (CBK). He achieved this feat largely through the use of derivatives, this in order to avoid official limits on share purchases. The folks at the airline formerly known as HNA used similar tactics when they pretended to invest gobs of borrowed money into Deutsche Bank AG (DB).
UniCredit’s Orcel says a full takeover of Commerzbank is an option, potentially creating Germany’s largest lender. Yet more than half of the staff of the German bank would likely be dismissed in a merger, a considerable shock for a country that is not growing and is not expected to grow at all in 2025. Our bet is that DB eventually will make a bid and gain the support of the German government. If not, then the next hostile bid could be for DB itself.
CBK is trading at 0.6x notional book value, yet Orcel apparently thinks that Commerzbank is good value. We wonder why UCG would pay anything at all for the crippled German bank. CBK had about half a trillion in assets at the end of June, but just $30 billion in net tangible capital, according to CapIQ. Assuming the usual skeletons in the credit closet for the average large Eurobank, CBK probably has no equity. But we can say the same about a number of US bank M&A deals.
Like many US banks, UCG’s Orcel seems prepared to overpay for the target in the name of generating nominal growth of "value." The LT chart for Commerzbank below is not pretty. Notice how volume in CBK has picked up since the 2008 debacle, but the share price has barely moved. The German government has a 17% stake in CBK.
Source: Bloomberg (10/04/24)
CBK shares have bounced from EU12 to EU16 over the LTM, although prior to 2008 CBK traded over EU200. UCG would need approval from the German government for a full takeover. Note that members of the German business community are not even putting up a real fight at the thought of takeover by the larger Italian rival.
"Unicredit has been quite good at integrating banks in Italy and CEE," notes Achim Düebel in Berlin. "German banks have made the silly mistake in the 90s to not expand to CEE (apart from Commerzbank’s ill-fated mBank engagement in Poland), and the French and Spanish markets are closed, so lack EU networks. I think a German-Italian merger focused on Mittelstand and mortgages would make more sense than, say, a German-French or a Deutsche Bank takeover."
In theory, CBK is only about 10% smaller than U.S. Bancorp (USB) at $623 billion in assets. At the end of Q2, the American bank had twice as much nominal equity and far stronger asset returns, but don’t get too excited. USB starts with minus $15 billion for the negative capital surplus, then add $75 billion in retained earnings, less $10.3 billion in accumulated other comprehensive loss for the negative mark-to-market on AFS loans and securities. That leaves just $46 billion in tangible capital, as shown below from the Form Y-9. Of note, we have not included the held-to-maturity assets in the net capital calculation for USB or CBK.
U.S. Bancorp | BHCPR | 06/30/24
Source: FFIEC
If interest rates are not going to fall below current levels and, more important, the rate cutting narrative at the Fed is on hold, what does this mean for the future?
First and foremost, a sudden change in the “inflation is dead” narrative likely means that Fed Chairman Jerome Powell could be retiring soon. The September rate cut marks the third time that the FOMC under Powell’s leadership has made a mistake in timing. When your stock and trade is confidence, timing matters.
Like the believers of the Church of Rome, investors in dollar assets trust in the leadership of the Fed as an article of faith. If the Chairman does not push the right buttons at the right time, however, then confidence -- that is, faith -- in the system suffers. Since Powell puts consensus within the FOMC first and foremost, the possibility of a split vote in November provides Powell with an opportunity to flee back to the safety of private life.
Second, a lack of consensus within the FOMC will impact markets very directly and in the same degree as the market rally before the September cut. A couple of readers have asked whether residential mortgage rates will go below 6% before year-end. Given the rally in Treasury yields over the past year and the rise in yields since the Fed rate cut, we think the short-term prognosis is more likely higher Treasury yields and mortgage rates as the year ends.
As we noted to subscribers to the Premium Service last week, banks are chasing assets and yields to such a degree that returns are being forced down. Funding costs are unlikely to follow suit, thus we may see a narrowing of net interest margins in Q4 after more promising results with Q3 earnings. The sudden interruption of the rate cut narrative, as the title of this post suggests, means that the FOMC may need a new leader to carry the message going forward. Markets are not expecting a change.
The collapse of the credit trade is making some banks regret asset sales made earlier in the year, but we think the real story for the end of 2024 will be higher Treasury market yields and residential mortgage rates, shrinking NIM at banks (after several better quarters) and greater uncertainty about the direction of US monetary policy.
As the FRED chart above suggests, the markets got their rate cut over the past six months and now may have to give some of that back. The 10-year Treasury note is over 4% for the first time since early August. The green line showing bank net income below may show an uptick in Q3 followed by a down quarter for the year-end 2024.
Source: FDIC
In our next Premium Service comment, we’ll be setting up readers for Q3 earnings for financials given the suddenly uncertain outlook for US interest rates.
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