• Financial sector repair is paramount for Europe
  • The euphoria over Abenomics was short-lived
  • Bond market turbulence – a perspective

This summer marks my 30th anniversary in banking. (I started at age 10.) One of my first revelations upon entering the industry was that banks actually want to make loans. As a mere customer prior to that, I had the opposite impression. The lending floor at my local depository was a dark, scary-looking place; my father warned me that if I ever asked to borrow, they would ask for my circulatory system as collateral.

Credit, I came to understand, was the driver of bank profits. Interest on loans, underwriting fees and asset management earnings are all tied to the level of financing in the economy. And in turn, the fortunes of an economy depended critically on the availability of capital from banks and the financial markets.

Today, the relative health of banks around the world goes a long way toward explaining differences in economic fortunes. As policy-makers seek ways to improve growth, addressing structural issues in their financial systems may be more effective than monetary or fiscal stimulus.

The global financial crisis did a good deal of damage to financial intermediaries. Losses on loans depleted their capital, and the loss of confidence depleted their liquidity. In extreme cases, leading institutions required government assistance and remain in various states of conservatorship.

From these common origins, the fortunes of banking systems in the United States and Europe diverged. Stronger loan quality, liquidity and bank capital supported an expansion of credit on this side of the Atlantic, while credit continues to contract in the Old World.

Hampered by losses and facing lingering recession, many European financial institutions cut back. Whereas capital markets supply a great deal of financing to U.S. consumers and businesses, this avenue is far smaller in Europe. As a consequence, credit has been restrained at exactly the time that Europe most needs it.

Making matters more challenging is the international drive to increase the level and quality of capital banks hold as a buffer against loss. Regulators are limiting the range of items that count as capital, asking for larger cushions and placing less faith in the risk-weighted measures that were preeminent prior to the financial crisis.

Concerns persist among regulators and the public alike that bank models estimating risk-weighted assets understate the true exposure faced by financial firms. As shown in the chart below, there is a substantial difference between these measures and simple ratios of capital to assets for European banks.

With investors skeptical about the true value of bank assets, European bank shares have stagnated while U.S. bank stocks have prospered. In fact, the European bank stock index shown above is trading at only 78% of its book value.

Finally, the health of banking systems in individual European countries has diverged. Stronger central banks offer a much more credible backstop, whereas smaller or weaker ones create worry that debt holders and depositors will be “bailed in” in the event of a crisis.

Yet even as markets and supervisors demand more capital, many European banks have little hope of raising it. The only option is reducing leverage. Restrictive credit conditions have combined with restrictive fiscal conditions to keep European growth from improving much.

There is, therefore, urgency surrounding discussions within the Eurozone over unifying the supervision of banks and creating a unified pool and procedures for resolving troubled financial firms. A structure of this sort would be much better positioned to deal with the sorts of situations that arose in Cyprus and Slovenia, with much lower risk of contagion. A single supervisor could also bring additional transparency to the industry and potentially provide a stronger stamp of approval that could rally confidence in the sector.

Negotiations have been going on for some time, with debate centering on how much power should be centralized. National authorities remain somewhat protective of their financial systems, given their importance to local economic performance. Progress has been slow, with some blaming relatively calm debt market conditions and the approach of German elections for the languor. The topic is on the agenda for the EU summit next week.

While China doesn’t have the challenge of consolidating bank oversight, they are facing the challenge of bolstering confidence in their banking system. Liquidity has suddenly become more difficult to come by, and speculation over solvency threatens to restrict credit. Facing problems candidly, while painful, may ultimately win back the trust that is essential to financial intermediation.

So instead of more quantitative ease or fiscal stimulus, countries might invest more attention in efforts to widen their credit channels. Something to promote loan demand might not hurt, either: A regulation requiring bright light and friendly faces on the lending floor would be my suggestion.

The Bloom Is Off the Chrysanthemum

The three arrows of Abenomics (government spending, an aggressive central bank asset purchase policy and structural reforms to boost long-term growth) propelled optimism about Japan’s economic future. Over the past month, however, in the eyes of investors it appears that those arrows have fallen to earth.

The Nikkei 225 stock market index has declined about 15% from its mid-May peak, after advancing more than 80% from mid-November. During the same period, the yen has traced a path from 79 yen per U.S. dollar to 103 yen in mid-May and back to around 95 yen.

Counter to expectations, the 10-year Japanese government bond (JGB) yield has advanced amid a great deal of volatility since the Bank of Japan (BoJ) announced a huge monetary stimulus package to address deflation. These market movements call for an explanation.

First, it appears that some of the foreign investment that lifted equity prices has been pulled back as foreigners recognize that recovery is a long process with considerable risk.

Second, the BoJ disappointed markets last week when it declined to extend the duration of its current bond-buying program. BoJ Governor Haruhiko Kuroda noted that the committee would consider such an operation in the future but sent a clear message that market trends would not guide monetary policy.

The fundamentals appear to be on Kuroda’s side. Japan’s first quarter real gross domestic product (GDP) was revised to a 4.1% increase, and the BoJ upgraded its assessment of the economy. A leading inflation indicator went into positive territory for the first time since 2006. It appears that the improvement in the near-term outlook has encouraged the BoJ to stay on the sidelines despite market pressure.

Still, investors may still be expecting a bit more “shock and awe.” The promised quantitative easing program, which could reach 60% of GDP, is off to a slow start. And the goal of 2% inflation is still far off.

Third, uncertainty over the remaining planks of Abe’s program is at play. His “third arrow” is a series of structural reforms seen as key to reviving business momentum in Japan. Less rigidity in labor markets, modified regulation and measures to improve compensation are key planks in the platform.

There will be elections next month in the upper house of the Japanese parliament. Mr. Abe is expecting to consolidate his support at that time. His popularity remains very high, but the recent market correction has not helped. A solid victory in July and a cabinet re-shuffle in September with reformists could result in structural reform. The question will then become whether new programs can overcome cultural frictions and achieve success.

The experience of the past month illustrates that Japan’s renewal is very much an evolving process. Policy-makers and investors will be asked to reserve judgment for a little while; after two decades of struggle, it doesn’t seem unreasonable to wait patiently for a little longer.

How to Differentiate Between 1994 and Now

The rapid move of the 10-year U.S. Treasury bond yield to around 2.4% from 1.6% at the beginning of May is one of the largest corrections of its kind. The Federal Reserve’s explicit plan to taper and eventually terminate its asset purchases, if economic conditions evolve to match the Fed’s expectations, triggered the most recent leg of the bond market’s retreat.

Commentators are wondering whether we are in for a repeat of the 1994 bond market carnage, which followed the Fed’s tightening of monetary policy. In that instance, the federal funds rate rose to 6% from 3% between February 1994 and February 1995, and fixed-income investors lost a bundle. The concern now is that we might mimic that pattern as the Fed moderates the current quantitative easing program.

Economic fundamentals clearly differentiate the present and 1994. First, the economy was operating roughly 2.0% below its potential capacity in the final quarter of 1993, just prior to the Fed’s tightening phase begun in early 1994. By contrast, the U.S. economy was 5.6% short of its potential as of the first quarter of 2013.

This suggests that the normalization of monetary policy need not be too rapid, as Chairman Ben Bernanke has suggested.

Second, the personal consumption expenditure price index, the Fed’s preferred inflation measure, was hovering around 2.0% in late-1993. Currently, it is below 1.0%. At present, the core inflation price gauge, which excludes food and energy, is close to 100 basis points below the December 1993 reading.

Projections of real GDP and inflation do not suggest an overheated economy in the near term. This should keep long-term rates under some control.

There is a complementary line of reasoning that suggests only moderate increases in long-term interest rates over the next 12 months. It notes that long-term interest rates are a composite of expected short-term interest rates. The Federal Reserve forecasts released yesterday suggest a gentle and gradual reversion of short-term interest rates to their long-term tendency of 4%. If one follows this path, 10-year interest rates should not be much higher than they are now.

Current economic fundamentals do not justify an aggressive tightening of monetary policy of the kind seen in 1994. So while yields may be volatile in the months ahead, we are unlikely to repeat that unpleasant history.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

© Northern Trust


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