While the Federal Reserve continues to send mixed signals about when exactly it will begin tapering its monthly purchases of Treasury and mortgage bonds, one thing is clear: the shelf life for aggressive economic stimulus is nearing. Many believe Fed Chairman Ben Bernanke will pull in the reins at some point this fall; the training wheels will likely come off all together in mid-2014. So what does this mean for Wall Street? Well that all depends where you’re working.
With the end of stimulus nearing, and the U.S. economy slowly yet methodically improving, near rock-bottom interest rates will be sure to rise. Historically, rising interest rates correlate with a downturn in fixed income revenues. This will likely occur again over the next two years, but it won’t be nearly as dire as in 1994, when banks were unprepared for the changing economic conditions.
As Goldman Sachs President Gary Cohn points out, rising rates often encourage investors to take on interest rate protection, fearing the numbers will continue to rise.
“One of the great fallacies that is out there in the world… is… that you can only make money in the fixed income business when rates are going down,” Cohn noted last month. “There is always business activity no matter what the rate cycle is.”
Cohn is right, but that doesn’t mean fixed income revenues won’t take a hit. Using historical analysis based on interest rates, slope of the yield curve, credit spreads, trailing industry inventory and industry net leverage, fixed income revenues will likely drop by 5% in 2014 and 11% in 2015, according to Brad Hintz, an analyst at Bernstein Research.
“Many of the cash businesses of fixed income will be facing a growing headwind and the business will be posting lower numbers as a recovering economy reduces the number of fixed income sectors that outperform,” Hintz said. “So don’t worry about another 1994, but it is safe to conclude that the bloom is off the rose of this fixed income cycle.”
With Bernanke’s recent suggestion that tapering is soon to begin, the pain already is stinging. The world’s biggest fixed-income managers saw record amounts of assets leave their funds over the last month.
The likeliest sector to see job losses during the period will be in fixed income, said Richard Lipstein, managing director at Gilbert Tweed Associates.
On the plus side, even as bond issuance will most likely decline, higher yields could lead to volatility in fixed income trading, says Peter Laughter, CEO of Wall Street Services.
The fallout for lenders is much more complicated. Thirsty for greater margins on loans, banks certainly won’t complain about rising interest rates, but the change won’t result in an immediate win. It will take some time for banks to see margin gains on their balance sheets.
Couple that with the fact that loan demand will likely tick downward following an interest rate increase, and the environment isn't all that sunny. Then there is the issue of debt securities, which banks have swallowed up as Bernanke has pumped stimulus funds into the economy. With an interest rate increase, banks will likely see “sizeable” unrealized losses, according to the New York Times, which won’t show up in P&L but do affect tangible book value.
More importantly, the losses are counted against capital under new Basel rules. That’s bad news considering U.S. regulators are already close to implementing a new standard that would force large banks to hold capital reserves equal to 6% of their total assets, twice the level set by global banking supervisors.
Banks have shown a proclivity to slashing underperforming business units, along with the asset sales, when they need to build up capital. Can they hold off until interest rate gains outpace losses in securities holdings? We’ll see. It could take two to three years for that to happen.
From a career perspective, employees handling refinancing could be at risk, said Lipstein.
Private Equity, M&A
Perhaps the biggest drawback of impending stimulus tapering is the waiting. There is a 100% chance interest rates will rise at some point, but when? The uncertainty is causing volatility in the markets, which has put the brakes on private equity and M&A activity.
Through five full months of 2013, the private equity market in the U.S. was rather healthy, especially compared to other parts of Wall Street. But recent volatility in the market has made buyers and sellers gun shy about inking deals, not knowing if their timing is right.
“An increase in volatility in the markets would certainly help trading commissions but potentially hurt the IPO business, as we have already seen a few isolated examples,” said Lipstein. HD Supply Holdings and private equity-owned CDW Corp. each had their IPOs fall flat in recent weeks. Others have delayed their offerings.
M&A activity in the U.S. has been strong compared to that in Europe, but it’s still down year-over-year, with second quarter activity particularly sluggish. Buyers don’t want to overpay, and sellers don’t give it away. And, as Bloomberg points out, credit is still cheap. Many potential sellers are taking on debt to stay independent rather than taking a buyout offer.
Activity should improve when Bernanke is done fiddling, but until then, dealmaking may remain sluggish. However, it’s way too early to suggest we’ll see job losses in dealmaking, said Lipstein.