This week, a triptych of Wall Street titans, Citigroup, Goldman Sachs and Morgan Stanley, all delivered a remarkably unified message: Bond trading is back. All three banks posted strong profit increases for the fourth quarter of 2016 versus the fourth quarter of 2015. The driver was a remarkable comeback in matching buyers and sellers of fixed-income securities, after a drought in what had long reigned as by far their most lucrative business.
Unlike with the “Trump Bump” in stocks, however, what’s propelled those gains isn’t uniform optimism for a thriving economy under President Trump. It’s sharply divided opinion over what’s to come. Donald Trump fans are betting on a boom that will prompt the Fed to lift rates, and rescue troubled corporate borrowers. The bears swear that Trump’s pro-growth agenda will fail, keeping the Fed on hold, and pushing highly leveraged players to the brink.
Those opposing world views mean the bulls are buying the junk bonds and corporates that safety-seeking, Treasury-loving bears are selling. And all of that action is sending billions to Wall Street’s matchmakers.
For the three banks, the trading revival is offsetting softness in M&A and both corporate and commercial lending. The uncertainty that’s driving trading is a downer for acquisitions. “For M&A and financial advisory, companies are delaying decisions because they just don’t know what the environment will be,” says Marty Mosby, an analyst with Memphis asset manager Vining Sparks. Super-low rates continue to depress income on lending portfolios. But stock investors, at least, are convinced that the banks will benefit from steeply rising rates and loads of corporate dealmaking moving forward. Since the election, Citi’s stock (C) has jumped 23%, while shares of Morgan Stanley (MS) and Goldman (GS) have soared 30% and 35%, respectively.
Whether those trends will materialize is highly uncertain. But trading is really already back, as demonstrated by the new numbers. In each case, it was trading that accounted for most of the year-over-year rise in earnings from Q4 ’15 to Q4 ’16. At Citigroup, the Institutional Clients Group, dominated by fixed income, posted an increase in earnings-before-taxes of 82%, to $3.6 billion, accounting for the bulk of the bank’s total rise of 36% to $5.1 billion.
Goldman Sachs doesn’t break out profits by business, but the trajectory revenues in different businesses track where earnings are waxing and waning. In Q4, revenues from FICC, an acronym for fixed income, commodities, and currencies—by far its biggest business—rose from $1.123 billion in the prior year’s quarter to $2.0 billion, or 78%. That increase represented virtually its entire year-over-year jump in quarterly revenues.
At Morgan Stanley, fixed income is less dominant; its equity sales and trading and wealth management businesses are larger than its bond franchise. Nevertheless, fixed income was the star of Q4, boasting revenues that rocketed from $550 million to $1.5 billion.
The year-over-year gains are so gigantic largely because bond trading virtually collapsed in late 2015, and the famine continued well into 2016. “The comeback began in Q3, and the numbers weren’t much higher sequentially in Q4,” says Mosby. “It’s really a story of the market getting back on track after everyone moved to the sidelines.”
A Boom With a Dark Side
It’s highly instructive to review the forces that pummeled, then revived trading in 2016, capped by the Trump phenomenon that’s churning trades and profits for Wall Street. In late 2015 through around March 2016, almost all investors shared the same dim, bearish view on bonds. The drop in oil prices caused yields on bonds issued by energy companies to soar, and the near-panic spread quickly to corporates. Whenever most investors are thinking the same way, the opportunity for trades is at a low ebb. Hence, the universally negative sentiment killed the action on bonds.
Around March, sentiment quickly and almost totally reversed. Oil prices rebounded, the economic outlook brightened. The future suddenly turned form bleak to rosy. Still, trading remained dormant for a simple reason: Investors were mostly thinking the same way, only this time the unifying view was bullish. Trading increased briefly as folks poured out of Treasuries and into junk bonds. But for the rest of the second quarter, investors just stuck with what they already owned.
Sentiment reversed again in June when the unforeseen Brexit vote shook the globe. Suddenly, turmoil reigned once again. Politics dominated the global economic outlook. Investors became radically divided on what to expect. And Trump’s surprise victory deepened the divide.
Today, the market is split into two basic camps. One group believes that Trump’s pro-growth stance will lead to far higher rates on Treasuries, but tighten spreads on junk bonds, because the better economy will enable low-grade borrowers to generate extra cash flow for repaying their heavy debt. So the economic optimists are dumping Treasuries, and loading up on riskier bonds that will increase in price if a thriving economy narrows credit spreads. They’re also purchasing corporates whose credit ratings should also improve, while hedging risk from possible interest rate increases by purchasing futures contracts.
The bearish camp believes that Trump’s agenda will either flop or won’t be enacted. They reckon the market is already pricing in much higher future growth. Indeed, the rate on 10-year Treasuries has jumped over a full point since July, to 2.4%, and bank stocks have soared on the expectation that curve will keep climbing. The skeptics predict that junk bonds, whose spreads have already narrowed, will suffer as growth remains tepid and strapped borrowers default. So they’re dumping high-yield bonds. They’re also buying Treasuries, and given their view of a troubled future under Trump, why not? They can get the same return today on the super-safe 10-year that a relatively risky, triple B-rated bond delivered several months ago.
A market that’s highly polarized, and split between folks who are equally enthusiastic about buying and selling the same bonds, is a gift to Wall Street. The reason is two-fold. First, both sides are in a rush to buy and sell, and the Trump bears are happy to hand their junk bonds, for example, to the Trump bulls. That swells the volume of trades, especially compared with periods where everyone likes the same securities.
Second, the sense of urgency means that investors are willing to pay Wall Street more to get in and get out. The firms are paid by tacking a markup onto the price buyers and sellers agree to, known as a “spread.” Right now, it’s the combination of strong volumes and wide spreads that are boosting profits.
The big new action in bonds is a symptom of a far broader phenomenon, the divisions over Donald Trump, and what his policies promise for America’s future. Many in the bond—and stock—markets are betting strongly that Trump will succeed. That conviction has bid up asset prices. America will need strong growth that swells profits and cash flows to rise sufficiently to justify those lofty valuations. If it doesn’t happen, the Trump bears will prosper, but millions of Americans will see the value of their 401(k) plans and investment portfolios shrivel. Uncertainty is good for Wall Street. But in the era of Brexit and Trump, the world is now a far riskier place to invest.
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