US stocks fell more than 1% overnight on concern over the strength of the US economy and tensions with Iran in the Strait of Hormuz.
Usually, the market doesn’t mind a bit of weak economic growth. It means central banks will hang around for longer with stock price supporting policies. But yesterday, the Fed said they weren’t too bothered by the weak first quarter US growth number, citing weather as the main issue.
So for the next few weeks at least, the market is on its own.
The steep falls in US stocks haven’t translated to weakness in the Aussie market today. ASX 200 futures are only down one point, and at the open, the market is flat.
So why is the Aussie market holding up today? That’s an interesting question.
It could just be that after two days of decent selling, the market has had enough. Time for ‘bargain hunting’…although there really isn’t much in the way of bargains.
The recent sell-off was all about the banks. While the past two days was somewhat of a short term capitulation, the sell-off actually started in mid March.
Take Aussie bank bellwether Commonwealth Bank [ASX:CBA]. It peaked at just below $97 per share on 23 March. It then trended lower…to around $93 on Tuesday. Then, in the past two days, it lost around $4 per share.
The standard line of thinking is that a strengthening Aussie economy meant interest rate cuts were off the table. Hence, bank stocks, often bought for the ‘yield’, weren’t as attractive.
There is certainly an element of truth to this. Falling interest rates are great for banks. It encourages debt accumulation and asset price speculation…all of which benefits the banks.
You can see the interest rate story through the lens of the government’s 10 year bond yield. Have a look at the chart below. It shows the yield on government 10 year bonds throughout 2015.
As you can see, bond yields fell sharply from the end of 2014 and during January 2015. This triggered a big rally in bank stocks and the market in general. That’s because falling bond yields make dividend paying stocks more attractive.
Then government bond yields went higher, peaking in early March. CBA’s share price bottomed at just under $90 around the same time. It then shot to an all-time high as government bonds yield fell again.
Bond yields have backed off in the past few weeks, which explains some of the banks’ share price weakness. But government bond yields are still below where they were at the start of March, yet bank share prices are at new lows.
This tells you the recent sell-off isn’t just about interest rate movements?
Today’s Financial Review provides a clue:
‘Almost $20 billion has been wiped off the value of the big four banks by sharemarket investors this week, partly because of expectations the prudential regulator will take quicker-than-expected action to deal with the threat posed by rampant property speculation.
‘New figures showed the banks expanded loans for property investments in the year ended March by 10.4 per cent, the highest rate since 2008 and more than the 10 per cent threshold imposed by the Australian Prudential Regulation Authority in December to stop a property bubble building in Sydney and elsewhere.’
Quicker than expected action? How about any action at all? For the past six months, the banking regulator, APRA, has stood by while a destabilising property boom gathered pace in Sydney and Melbourne.
Its one token effort to contain the boom was to write a letter to the banks telling them to go easy on investor lending and restrict it to 10% annual growth. For the most part, the banks ignored the letter and went on taking advantage of easy money, which is what banks do.
But now, there is a fear that APRA could actually do something useful. My guess is that the RBA wants to cut rates again…and again…to get the Aussie dollar down. It doesn’t buy the Adam Carr argument that the economy is on the mend.
But it doesn’t want to risk further price gains in the housing market. That will only increase financial instability in the longer term.
So it’s having closed door talks with APRA, telling them more rate cuts are contingent on more effective macroprudential regulations.
That the country’s top financial bureaucrats couldn’t sort this out proactively is a disgrace. APRA should’ve been on top of this during the RBA’s rate cutting cycle throughout 2013.
Instead, the big banks took advantage of the rate cuts and have been able to get away with employing massive leverage to punt on housing. Chris Joye, writing for the Financial Review, recently shed light on just how significant this leverage is:
‘Indeed, the regional banks in their FSI [Financial Services Inquiry] report draw attention to the remarkable fact that one major bank holds virtually no capital at all against one-third of its entire mortgage book with a risk-weight of less than 2.9 per cent. This means the bank is leveraging 270 times when providing this finance.
‘Another major bank revealed in its FSI response that it holds only 1.3 per cent of equity capital against its entire Aussie home loan book, which translates into 77 times leverage on hundreds of billions of dollars worth of loans.’
Wow. And our banks are the safest and best regulated in the world, huh? No wonder David Murray is worried about capital levels. The amount of leverage they’re working with is dangerous.
For the uninitiated, when a bank makes a loan, it needs to set aside capital in the event there is a loss. The big four banks plus Macquarie are allowed to set their own capital weightings, apparently because they’re big enough and smart enough to do so.
I don’t know about you, but to me it looks like they’ve been taking the mickey big time. They’re leveraged up to the eyeballs and very much at risk from a house price correction. Luckily, that will never happen because this is Australia and it’s different here.
Anyway, the RBA is clearly in a panic about this. It wants to cut again but needs APRA to do something to stop the lunacy in the housing market. In the Financial Review’s Banking and Wealth Summit held this week, APRA Chairman Wayne Byers said:
‘…[he] would act “sooner rather than later” to implement the financial system inquiry’s call for the big four banks and Macquarie to hold extra capital against mortgages, which would be likely to hit profit and dividends.’
The RBA meets to decide on interest rates next week. Will they stay on hold and wait for APRA to get its act together, or will they cut in the expectation that changes are on their way?
It’s a close call. Either way, it looks like the halcyon days for the banks might be fading out of view.
for The Daily Reckoning Australia