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Yield curve inversion sounds recession alarm bell – Industry roundup: 4 July

US yield curve hits deepest inversion for 42 years

A key segment of the US Treasury yield curve approached its most inverted level since 1981 on Monday as traders priced in expectations of further Federal Reserve policy tightening this year to bring resurgent inflation back nearer its 2% target rate.

The two-year note’s yield exceeded the 10-year rate by as much as 110.8 basis points as the shorter-maturity rate reached 4.96%. The inversion touched 110.9 basis points in March, a level last seen in the early 1980s, according to data compiled by Bloomberg.

The inversion eased to around 108.5 basis points after the Institute for Supply Management (ISM) manufacturing gauge for June unexpectedly declined to a three-year low. In a shortened trading session ahead of today’s Independence Day holiday in the US, Treasury two-year yields dropped to as low as 4.84% before climbing to nearly 4.94%. The 10-year yield rose to about 3.85%.

“The near-term risks are that more rate hikes must be priced, that the Treasury curve flattens more, and that the pace of slowing both within the inflation and employment data does not satisfy policymakers and the markets,” John Brady, manging director at finance broker RJ O’Brien, wrote to clients.

The US Treasury yield curve is regarded by many investors as a time-honoured recession signal.

The yield curve inverts when shorter-dated Treasuries have higher returns than longer-term ones. It suggests that while investors expect interest rates to rise in the near term, they believe that higher borrowing costs will eventually hurt the economy, forcing the Fed to later ease monetary policy.

The phenomenon is closely watched by investors as it has preceded previous recessions. The yield curve briefly inverted to 42-year lows yesterday as investors increasingly expect the Fed to raise its benchmark borrowing rates to rein in inflation. Rate futures markets reflect a greater than 80% chance of a quarter-point hike later this month but much less conviction the Fed will proceed beyond that, even though Fed officials said last month that a second quarter-point increase was likely before the end of 2023.

When short-term rates increase, US. banks raise benchmark rates for a wide range of consumer and commercial loans, including small business loans and credit cards, making borrowing and mortgage rates more costly for consumers.

When the yield curve steepens, banks can borrow at lower rates and lend at higher rates. When the curve is flatter their margins are squeezed, which may deter lending.

Bank of America and Citi query Fed stress test results

Two of the biggest US lenders, Bank of America (BoA) and Citi are questioning the Federal Reserve’s projections for their future income, the latest sign of tension around the central bank’s annual stress tests.

Both banks said that they are in discussions with the Fed after their own estimates differed from those of the US central bank. The results of the yearly exams and projections are closely watched because they are a key factor in determining how much banks can return to investors in payouts. 

The results released last week showed that the biggest 23 US firms can withstand a severe global recession and turmoil in real estate markets. While regarded as a positive sign for the industry, the tests remain a flash point. Some advocates argue the exams need to be much tougher, while industry groups are girding to fight a looming overhaul. 

However, BoA is querying the Fed’s projections and said that it was talking to the central bank to “understand differences in other comprehensive income over the 9-quarter stress period.” Separately, Citi said it was looking to “understand differences in non-interest income.” In BofA’s case, the Fed’s projection was rosier. For some of Citi’s forecasts, it was the opposite. 

In one example of the discrepancy, the Fed projected that BoA would report US$22.3 billion in other comprehensive income over a nine-quarter period under a hypothetical set of adverse economic conditions. BoA itself projects US$12.5 billion for that metric during the period that began in the first quarter of this year. The Fed also expects BoA to record a US$23 billion pretax loss during that time frame, while the company forecasts an approximate US$52 billion cumulative pretax loss.

As for Citigroup, its own stress test results predicted US$64.4 billion of non-interest income in the nine-quarter period, while he Fed forecast a figure of US$43.9 billion.

The news follows recent reports suggesting that the four largest banks in the US now have a total of US$205 billion in unrealised losses on their balance sheets, according to a new report. BoA alone has reportedly incurred a paper loss of about US$109 billion due to its decision to invest heavily in US government bonds, a significantly higher figure than those of its main competitors.

According to one report: “As a result of the repricing of bonds, BoA’s investment portfolio suffered substantial paper losses, surpassing US$100 billion, as disclosed by the Federal Deposit Insurance Corporation (FDIC) at the end of the first quarter. These losses stand out prominently when compared to the unrealised losses incurred by rivals.

“For reference, the unrealised losses of key competitors JPMorgan Chase, Wells Fargo, Citigroup and Morgan Stanley amounted to only approximately US$37 billion, US$42 billion, US$24 billion and US$9 billion respectively.”

Despite the paper losses, the Federal Reserve says that BoA and its peers fared well in its recent stress test on the banking system.

The test, which simulated “severely adverse” conditions in US economy, found the top 23 banks in the US would remain above their minimum capital requirements in a hypothetical recession, despite total projected losses of US$541 billion. The downturn scenario modelled a global downturn marked by a 10% surge in unemployment, a 40% decline in commercial real estate values, and a 38% drop in housing prices.

Despite the projected massive losses, US banks would still manage to operate smoothly, and be able to pay any outstanding financial obligations and write new loans. In response to the strong stress test results, several of the major banks have already announced plans to increase shareholder distributions, including JPMorgan, Morgan Stanley, Wells Fargo, and Goldman Sachs.


China announces export curbs on chipmaking metals

China is to restrict the exports of two metals key to the manufacturing of semiconductors, its commerce ministry has announced.

These new regulations are being introduced on the grounds of national security and from August 1 will require exporters to seek a license to ship some gallium and germanium compounds. Applications for these export licenses must identify importers and end users and stipulate how these metals will be used.

“China’s move to restrict exports of some rare earth metals, used in highly sought-after products such as semi-conductors, appears to be a tit-for-tat move, in response to US curbs on the sales of chips which are in high demand for AI capabilities,” commented Susannah Streeter, head of money and markets at UK financial services group Hargreaves Lansdown.

Coming just days before Janet Yellen, the US Treasury Secretary is due to visit Beijing, the policy is likely to have been designed to put pressure on the US to release its current export bans and drop further curbs which are expected.

Gallium and Germanium prices jumped after the policy was announced. “China is the dominant producer of the metals and exported 25% more gallium last year, compared to 2021 – it’s the base ingredient for made gallium arsenide which is used in the electronics industry, particularly to make semi-conductor wafers which are highly heat resistant,” said Streeter.

“Germanium also has multiple applications in electronics particularly transistors and is used to make lenses for weapons sighting systems. Given that China is such a large exporter, it’ll take considerable time for other producers to ramp up production, which could set off fresh inflationary pressures in industries which had been enjoying some respite as supply chain pressures eased. However, over the longer term it may accelerate moves to make industries around the world to become less dependent on China.”

At a  press conference in Beijing on Tuesday, China’s Ministry of Foreign Affairs spokesperson Mao Ning insisted that the country’s export controls are in accordance with the law and are not targeted at any specific country.

Manufacturing slowdown across Asia's main economies

China’s manufacturing activity was only sluggish in June as companies turned more cautious about their output outlook, according to a private survey.

The Caixin/S&P Global manufacturing purchasing managers’ index (PMI) eased to 50.5 in June from 50.9 in May, indicating a marginal expansion in activity. The 50-point index mark separates growth from contraction.

The figure followed last Friday’s official survey that showed factory activity extending declines, adds to evidence the world’s second-largest economy lost momentum in Q2 2023 as demand weakened.

“In contrast to the official manufacturing PMI, the Caixin manufacturing index declined in June. Taken together, the average of the two is consistent with a slight deterioration in factory activity last month,” said Julian Evans-Pritchard and Sheana Yue, China economists at Capital Economics.

The Caixin manufacturing PMI surveys around 650 private and state-owned manufacturers and, according to economists, focuses more on export-oriented firms in coastal regions, while the official PMI surveys 3,200 companies across China.

Elsewhere, business surveys showed that Asia’s factory activity slumped in June, as sluggish demand in China and advanced nations clouded the outlook for the region's exporters.

While manufacturing activity expanded marginally in China, it contracted in powerhouses Japan and South Korea as Asia's fragile economic recovery struggled to maintain momentum.

The surveys underscore the toll China's weaker-than-expected rebound from zero-Covid lockdowns is inflicting on Asia, where manufacturers are also bracing for the fallout from aggressive US and European interest rate hikes.

“The worst may have passed for Asian factories but activity lacks momentum because of diminishing prospects for a strong recovery in China's economy,” said Toru Nishihama, chief emerging market economist at Dai-ichi Life Research Institute.

“China is dragging its feet in delivering stimulus. The US economy will likely feel the pain from big rate hikes. These factors all make Asian manufacturers gloomy about the outlook.”

The impact is being felt in Japan where the final au Jibun Bank PMI fell to 49.8 in June, returning to a contraction after expanding in May for the first time in seven months. New orders from overseas customers decreased last month at the fastest rate in four months reflecting feeble demand from China, the Japan PMI survey showed.

South Korea's PMI fell to 47.8 in June, from 48.4 in May, extending its downturn to a record 12th consecutive month on weak demand in Asia and Europe. Factory activity also contracted in Taiwan, Vietnam and Malaysia, the PMI surveys showed.


Australia’s central bank holds off raising rates again

The Australian share market has closed higher, buoyed by the Reserve Bank of Australia (RBA) leaving its cash rate target on hold at 4.1% at its July meeting after a series of rate hikes in previous months.

Economists had been divided in their forecasts ahead of the central bank’s decision, with about half expecting the pause while others anticipated another 25 basis point increase.

RBA governor, Philip Lowe, said the bank needed time to assess the impact of four percentage points of rate hikes before it acted again. “The higher interest rates are working to establish a more sustainable balance between supply and demand in the economy and will continue to do so,” Lowe said in a statement. 

“In light of this, and the uncertainty surrounding the economic outlook, the board decided to hold interest rates steady this month.”

Expectations that the central bank would hold off from hiking rates this month were encouraged by the minutes of the RBA’s June board meeting, indicating that the decision on whether to hike the rate or leave it unchanged was "finely balanced".

The Australian Bureau of Statistics (ABS) monthly consumer price index for May issued since then showed headline inflation fell back to 5.6%, the lowest in just over a year.

Former RBA board member Warwick McKibbin was among those calling for the central bank to pause this month. He predicted a global "deflationary shock" was emerging as supply chains recovered from the twin disruptions of the Covid pandemic and Russia’s war on Ukraine.

The RBA also held off in April this year, but in other months has raised the cash rate 12 times since it began tightening monetary policy in May 2022. This month’s pause may only be temporary as most economists and markets expect the central bank will increase the rate at least one more quarter-point to 4.35% in the coming months.

RBC’s acquisition of HSBC Canada not yet a done deal

Royal Bank of Canada’s proposed C$13.5 billion (£8 billion) acquisition of HSBC Canada could miss its late 2023 scheduled completion date.

HSBC, Canada’s seven largest bank, originally announced in November 2022 that it had struck a deal to sell its Canadian business to RBC, the country’s largest, as it continues to shrink its global footprint and focus on the Chinese market. The proposed deal would represent the largest domestic bank acquisition in Canadian history.

The sale of its Canadian operation – which has more than 130 branches and 780,000 customers – follows HSBC’s plans to exit retail banking in the US and France, announced last year. But while the latter were loss making, the Canadian business has been profitable, earning HSBC C$490 million before tax in the first half of the year.

However, in May it was announced that Competition Bureau Canada was reviewing the deal to assess whether the deal would result in a substantial lessening or prevention of competition. The Competition Bureau has issued a request for information (RFI) to help gather facts about the proposed acquisition. The watchdog is seeking information to further assess potential impacts on competition in personal and business financial services.

Last month the Federal Finance Department said that it too was launching a public consultation on the deal and was seeking feedback on whether it is in the best interest of the financial sector.

More recently analyst Jordan Sauer has questioned the planned acquisition. “This, at a time of extraordinary debt levels in the Canadian financial system, looks like a terrible move by Royal Bank,” he writes.

“British Columbia's HSBC customers aren't happy about this acquisition, with many saying they value HSBC’s global network. Royal Bank is attempting to console these customers. reporting “You can expect the types of international capabilities that HSBC Canada’s clients value.”

Sauer also suggests that RBC is overpaying. “At a C$13.5 billion dollar valuation, Royal Bank would be paying 2.3x HSBC Canada's book value C$5.9 billion and 17x earnings of the C$792 million as of 2022. This is a hefty price to pay,” he points out.

“HSBC Canada has huge exposure to what looks like a Canadian housing bubble, doing the vast majority of its business in British Columbia and Ontario where home prices are quite extreme. Vancouver and Toronto ranked number three and number 10 among the world's least affordable housing markets,” Sauer adds.

“The proposed HSBC Canada acquisition comes at a precarious time and may leave shareholders vulnerable. Combined with recession loan losses, Royal Bank may be forced to cut its dividend or issue shares. RY's stock trades at a huge premium amid elevated risks in Canada.”

Thailand’s DIF web portal introduces electronic bond offerings

The Stock Exchange of Thailand (SET) has joined forces with the Association of Thai Securities Companies (ASCO) and the Thai Bankers' Association (TBA) to launch a digital infrastructure for fully electronic end-to-end bond offerings.

The end-to-end system covers issuance, filing, subscription, payment and delivery.

The infrastructure aims to increase the efficiency and transparency of the Thai capital market's services, reduce costs and increase access for both fundraisers and investors.

The Digital Infrastructure (DIF) web portal is expected to enhance regulatory efficiency and digitally transform the country's capital market to keep pace with rapidly changing global trends.

"This portal marks an important turning point in the capital market, connecting the work of market participants to transform it into a fully-digitised process to create a competitive edge, boost efficiency and push the capital market towards sustainable growth," said Thawatchai Pittayasophon, acting secretary-general of the Securities and Exchange Commission.

The regulator initiated the digital infrastructure for the capital market towards the end of 2019 with the support of the Capital Market Development Fund (CMDF). The project is included in the fourth. Thai capital market development plan (2022-27).

SET president Pakorn Peetathawatchai said the DIF web portal provides end-to-end bond offerings in the primary market electronically. The process includes. the settlement and delivery of debt instruments in scripless form.

The system was financed by the Capital Market Development Fund (CMDF) and is owned by CMDF Digital Infrastructure Co, while the Thai Bond Market Association (ThaiBMA) is the system operator in terms of day-to-day operations.

Somjin Sornpaisarn, president of the ThaiBMA, said the DIF Web Portal plays a dual role as a debt instrument registrar, which is one of the association's core missions, and the project's business operator.

SGX Nifty becomes GIFT Nifty as trading feud ends

Derivative contracts with a notional value of about US$7.5 billion traded in Singapore have shifted to India this week as a cross-border trading link between the two Asian countries’ main bourses becomes fully operational.

SGX Nifty, the Singapore Exchange traded futures on India’s key equity NSE Nifty 50 Index, will be known as GIFT Nifty as of July 3. All outstanding orders are being transferred to the Gujarat International Finance Tech – aka GIFT – City, a new financial hub in the western Indian state of Gujarat. 

The switch from SGX to the NSE International Exchange at GIFT City also highlights partial success of Indian Prime Minister Narendra Modi-led administration’s attempts to attract India-centric trading that had moved to global financial centres such as Dubai, Mauritius and Singapore to its shores.

“We are expecting the liquidity pool to grow as all orders from Singapore will be routed into our platform while local brokers from IFSC can also trade,” said V. Balasubramaniam, chief executive officer of NSE IX Ltd., a unit of National Stock Exchange of India Ltd. “Contracts having open interest of about US$7.5 billion are getting switched.”

The move fully settles a five-year old feud between National Stock Exchange of India Ltd. and Singapore Exchange over the latter’s plan to introduce single-stock futures trading on shares of some of India’s largest companies as India sought to develop its equity market. The dispute was resolved amicably after briefly entering a legal battle. 

Nifty derivative contracts were the second-biggest contributors to SGX’s equity-derivative volumes after SGX FTSE China A50 Index futures in the fiscal year 2022, and helped expand the bourse’s revenue from higher average fees and volumes.   


Deutsche Bank completes Postbank IT integration

Deutsche Bank confirmed that it had completed a fourth and final phase of a years’-long technology integration process with Postbank over the weekend.

Germany's largest bank said it would result in cost savings in 2023 and 2024, with annual savings of €300 million (US$326.52 million) from 2025.

Postbank was acquired to act as Deutsche Bank’s retail banking division. The process was started back in 2008 and the acquisition was completed in 2012 for a cost of €6 billion.

However the systems integration part of the transaction proved complex. The fourth and final part of the integration was scheduled to be completed last year but was subject to a delay.

The integration, which has been dubbed Project Unity, will see 19 million customers consolidated onto a single platform as the Postbank software and hardware is decommissioned.

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