It’s difficult to ignore the amount of liquidity injected into the system by policymakers since the start of the COVID-19 pandemic. Whether it was the Federal Reserve (Fed) stepping in with its fourth round of quantitative easing (QE) to prevent a capital markets crisis or the federal government providing programs and stimulus checks for relief to small businesses and individuals to stave off an economic one, an unprecedented amount of liquidity has found its way into the economy. These actions helped mitigate the negative effects on economic activity from the COVID-induced shutdown; however, their effects on capital markets are still ongoing.
This week’s chart shows a simple average of loan-to-deposit ratio for the four largest U.S. banks (JPMorgan, Bank of America, Wells Fargo and Citigroup). Deposits have risen materially as a percentage of loans since March 2020. Higher savings — anecdotally, I have not found myself spending much as I rarely leave my home — and tepid loan growth have driven this ratio to the lowest in decades. Banks need to make loans to earn net interest margin on their deposits, but with a surge in deposits and an absence of loans being made, banks have had to turn elsewhere.
This chart also shows the Agency Mortgage-Backed Security (MBS) Option-Adjusted Spread (OAS) Index and the discount margin (DM) for new issue AAA collateralized loan obligations (CLOs). The spreads — or excess yield you would earn on these investments above the risk-free rate — has trended downward (tighter) over the past year, suggesting banks may be putting deposits to work purchasing these assets. Historically, banks have been buyers of agency MBS, but recent data releases have shown that banks have increased their weighting in the asset class. Banks, however, compete with the largest buyer in town, the Fed, who continues to purchase agency MBS during QE4. This demand from two deep-pocketed buyers has driven the OAS on agency MBS to all-time lows. In CLOs, an asset class that is historically cheap but has not typically been a staple for banks, we see signs of increased demand. Special tranches (bonds) in AAA CLO new issuance are being carved out to make CLOs more palatable holdings for a bank’s capital requirements.
Key Takeaway
Bank demand has driven agency MBS valuations to historically rich levels and CLO spreads to multi-year tights. Positive demand technicals can still support valuations. However, I will be watching for announcements or data that may precede any cessation in demand from banks and the Fed. While I expect the Fed’s plans to wind down QE4 to be well-telegraphed, banks may change course quickly if loan demand picks up in a reopening economy or if banks are allowed to return more capital to shareholders via dividends and buybacks.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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