With earnings season growing closer, banks are beginning to report on their initial estimates of how they fared during the “taper summer”. So far, it is not looking like they did well at all (not that that was a surprise). Despite all their elegant models and simulations, including risk/hedging systems, traditional statistical evaluation, no matter how complex, has trouble with “tail events”. The bond/rate selloff, which was really dollar “tightening”, caught them completely unaware.
“’We currently anticipate debt sales and trading revenues in the third quarter to decline significantly from last year,’ Jain [co-CEO] said at the event.”
“Citigroup has suffered a significant decline in trading revenues that threatens to depress its earnings, according to people familiar with conversations between investors and the bank in recent days.”
“Barclays said last week that income had fallen “significantly” in the investment bank in July and August because of lower fixed-income revenues. Credit Suisse issued a similar warning.
“Last week, David Mathers, Credit Suisse’s chief financial officer, warned investors that the bank’s fixed income trading performance had suffered from a market decline this summer.”
“Earlier this week US investment bank Jefferies reported an 83 per cent fall in net income in its fiscal third quarter – which ended in August – on the back of lower bond revenues.”
Reuters helpfully notes that these potential “unexpected” revenue declines stand in stark contrast to the previous quarter,
“In the second quarter, Citigroup posted a 42-percent jump in profit as bond trading revenue gained and stronger home prices helped the bad mortgages on its books.”
The race is on to begin quantifying the industry-wide effects:
“Atlantic Equities expects fixed-income trading revenue at the biggest U.S. banks will probably drop 20% in Q3 from a year earlier and cut its EPS estimates for Goldman Sachs (GS), Morgan Stanley (MS) and Citigroup…The trading woes add to weakness in what was once a robust segment, further hurting prospects for Q3 earnings.” [emphasis added]
More than anything, I think this adds to the weight of evidence that banks were all onboard for unending QE, and further, they positioned themselves exactly for it. That the Fed began to worry about asset bubbles in housing and junk bonds (among other asset classes) was never anticipated, nor did it show up in models. That is what swap prices say, and now we can add bond trading (which probably includes collateral calls and changes in IR swap prices as well) to that list.
This highlights a systemic weakness in banks as they all pile in one direction. Not only does it create conditions for the dreaded crowded trade (as everyone suddenly looks to hedge or sell at once), it exposes the leverage system as built upon an illusion. Despite all the mathematical, Ivy League talent in the world, they still cannot accurately predict or model the most important variables, like vega, to incorporate “low probability” events.
Once the Fed began to detail an interest in asset inflation and bubbles, by May the hedging calculations surely were unprepared for the sudden burst of volatility across all the funding and rate markets. It just wasn’t a likely or even semi-likely path in these simulations, and dynamic hedging requires an estimate for the most probable (read: lowest cost) trajectory or “central tendency”. If you don’t expect high volatility, then you don’t hedge for it.
I think that illustrates an important lesson in QE. The Fed before 2013 took it as a near-mandate to suppress the idea of “tail risk.” Banks viewed that stance as hard policy and incorporated it into their portfolio and hedging models, especially vega. That means they were positioned for eternal QE with little expectation for volatility. The bond trading results suggest that they may still be positioned as such. This might get interesting if the dollar tightening continues, particularly if hedging becomes relatively more expensive (which swap positions are hinting).
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