Play the Hero in Regional Banks

Markets started 2024 where they left off in 2023. The S&P 500 lead the way (+1.6%) on the strength of the Magnificent 7 (excluding Tesla). The MSCI all country world index and TSX rose a modest 0.3%. Bucking current trends, stocks were able to log gains in the face of weak bond performance, as iShares 20+ Year Treasury Bond ETF (TLT) fell 2.3%. Bond weakness helped drag down gold’s performance as it fell 1.2%. Oil was the winner on a cross-asset basis, rising 6% as tensions increased across the Middle East. The slowing Chinese economy and climbing U.S. commercial crude inventories had conflicting effects on oil prices as the month ended. The U.S. Dollar, as measured by DXY, rose 1.8% and the Canadian Dollar weakened 1.3% versus the greenback.

Performance would have been stronger, but the S&P 500 gave up 1.6% on the final trading day following two noteworthy events. First, the U.S. Treasury released the documents and data relating to its borrowing and debt management policy for the quarter, called the Quarterly Refunding Announcement. While the amount of debt fell short of estimates, the fact that the Treasury reported an increased number of coupons, or debt beyond 3-month T-Bill, weighed on markets. Increasing the supply of longer-dated debt prompts questions about the source of the demand and the rate needed to attract those buyers. If rates to rise in the quarter with low demand, all asset classes come under pressure. Next, the US Federal Reserve maintained its policy rate in their 31-Jan announcement. While this was in line with expectations, Fed Chair Powell specifically downplayed a March rate cut in his press conference. We were clear in our pessimism around the amount of cuts priced into the market in our December 2023 letter. However, the overall hawkish tone blindsided the market. Despite the 1.6% drop in the market, it is noteworthy that on a net basis, the S&P 500 still had more companies hitting a new 52-week high than a 52-week low, marking a 63-day streak for the index.

Worries resurfaced in January about the soundness of the U.S. regional banks. The Fed confirmed they would not renew the emergency Bank Term Funding Program that was put in place to stabilize U.S. regional banks in March 2023. Additionally, the New York Community Bank (NYCB) released a quarterly earnings report that missed across the board and revealed a substantial increase in loan loss provisions. Recall that NYCB was the bank that acquired Signature Bank’s assets when it failed. NYCB fell as much as 45% intraday, closing 37% lower. This sparked fear of another crisis, as the SPDR US Regional Bank ETF (KRE) dropped 5.9% on the day. U.S. yields followed suit, mimicking the stark fall suffered in 1Q23. The 10-year U.S. Treasury yield fell 9.2bps on 31-Jan-24 to end the month at 3.97%, erasing most of the losses in 10-year bonds for 2024. In the past, the Fed commented that the solvency of regional banks would factor into their rate decisions. As such, markets may be pricing some level of future easing if further deterioration occurred in the sector. Alternatively, investors may be anticipating tighter lending standards to help ease balance sheet concerns. Reducing the flow of credit to small businesses and households will slow the economy, which corresponds to falling bond yields and slumping GDP growth. As the chart below demonstrates, U.S. Regional Banks have experienced two significant drops of about 20% in the past twelve months. Both collapses, were followed by rebounds of 30%.  The regional bank stocks are buckled again … the dog is on a leash, licking his face … when will they wake up and rise again.