The Fed Is About to Light the Fuse on This $14 Trillion Market

The Fed Is About to  Light the Fuse on This  $14 Trillion Market

Aussie investors are often misled when it comes to US stocks.

All we ever hear about are big tech firms.

You know the names: Facebook, Apple, Amazon, Netflix and Google.

And it’s not without justification.

They have led the huge surge in US stocks over the last nine years.

In fact, they’re even causing short-term interest rate signals to spike around the world as they shift their huge cash hauls back to America.

But there is another sector of the US market that’s just as important for the US economy and the direction of asset markets from here.

They don’t get the same press. And they certainly don’t get the same affection.

But they can give US stocks a big lift when they really start to fire.

That could be about to happen…

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This sector is crucial to the US economyand to Australia

If you haven’t guessed, I’m talking about the US banks.

The major firms here are about to report their latest earnings.

You might be familiar with the names I’m talking about: JPMorgan Chase, Wells Fargo and Citigroup.

Their earnings reports will provide huge insight into the state of the US economy and the outlook for markets from here.

Banks are the lynchpin of any economy. They control the credit markets, by and large.

The more people borrow, the more spending and economic activity takes place.

This is important for us here in Australia.

A booming America will keep Aussie shares in a positive environment.

Why are banks so important?

I’m sure you’ve read for years about quantitative easing (QE) in the US. That was the policy former Chairman of the Federal Reserve Ben Bernanke put in place after 2008.

The QE term is meaningless to most of us. But here’s how Ben Bernanke described it: ‘credit easing’.

The powers that be want banks to lend for the most part.

And they’re making it easier for them to do just that.

Trump’s administration has already loosened banking regulations.

It’s part of the reason the US bank index is up about 40% since Trump was elected.

Now we have news there are even more changes coming.

The Wall Street Journal reports that the Federal Reserve is proposing loosening the ‘supplementary leverage ratio’.

This affects eight of the largest banks in the US.

It means these US banks would not need to hold so much capital against their loans.

That would mean they’d be able to increase lending, all else being equal.

Why would regulators push for this?

One answer is to help US homebuyers.

Happy voters get to buy houses

The cost of a 30-year mortgage in the US is now rising. There’s a shortage of homes in the nation. Borrowers are struggling with affordability.

The easiest way to fix this is by tweaking regulations: Make it easier for banks to lend. Loosen the deposit and income requirements a touch. And keep the voters happy.

What’s more, rising long-term rates are usually good for banks.

In March the US Federal Deposit Insurance Corporation, which provides insurance to depositors in US banks, said that the net interest income for US banks rose 8.5% in the fourth quarter from a year earlier.

The US banks are as sneaky as ours it seems.

Even though the Fed is raising short-term rates, the commercial banks haven’t been passing on this benefit to depositors.

That keeps their cost of funding lower.

But wait!

Nothing is ever that simple.

The Treasury ‘yield curve’ is very flat at the moment. This refers to the gap between short-term (two-year) and long-term (10-year) rates.

It’s running the risk of inverting.

This is when short-term rates rise above long-term rates.

There’s good historical evidence that a recession and/or a peak in the stock market will happen within two years after this happens.

My only hesitation is that so many people are watching it right now that it may not ‘work’ this time as an immediate recession signal, or within the same timeframe.

After all, the yield has inverted before without a recession. It’s not foolproof.

Here’s what I think will happen in the immediate future:

Banks are like any other business. They gravitate to where the returns are highest.

If the 10-year Treasury bill isn’t paying much, banks could go hunting for higher-risk borrowers that bring a higher interest rate.

For example, the 10-year Treasury currently pays 2.84%.

A fixed 15-year mortgage is 3.86%.

US mortgages are a US$9.33 trillion market. That’s BIG.

Some data from the Fed recently suggests commercial US banks reduced their Treasury holdings in February.

I’m watching for increased signs of mortgage and private sector credit growth from the US banks.

Stay tuned. Rising credit growth and strong earnings from the wider US stock market could take the markets up over the next few months.

Now is still the time to be accumulating stocks.


Callum Newman Signature

Callum Newman,
Editor, The Daily Reckoning Australia