Will They Let Them Leave?

Monday, 22nd February, 2016
Melbourne, Australia
By Kris Sayce

  • Costs up for banks
  • Is it over?

So, Britons will vote in a referendum on 23 June to decide whether to stay in or leave the European Union.

The UK Prime Minister, David Cameron, will campaign to stay in the EU.

The Mayor of London, Boris Johnson, will campaign to leave the EU.

According to the latest report in the Financial Times:

Foreign bond buyers have started to raise concerns about the effect of “Brexit” on UK companies and banks, in the latest sign of growing uncertainty over the impact of the British referendum on EU membership.

Debt bankers said uncertainty surrounding the UK vote will not prevent financial institutions from selling new bond issues, but is likely to have implications for the price at which they are sold.

The press has been full of stories over the weekend about the UK referendum.

However, they all seem to have overlooked an important point.

The result of the referendum isn’t so much about whether the British will vote to leave the EU; more to the point, it’s whether the EU, the British political establishment, and the cabal of bankers will allow Britain to leave if it votes to do so.

We watch with (a tiny amount of) interest.


Over the weekend, the Dow Jones Industrial Average fell 21 points, or 0.1%.

The S&P 500 barely changed at all, falling just 0.05 points. The NASDAQ actually gained, closing up 16.9 points, or 0.4%.

In Europe, the FTSE 100 index fell 21 points, or 0.4%.

The German DAX index fell 75.6 points, or 0.8%.

Meanwhile, in trading today, Hong Kong’s Hang Seng index is up 195 points, or 1%. China’s Shanghai Composite index is up 59 points, or 2.1%.

And on the Aussie market, the S&P/ASX 200 index is up 43 points. That’s a 0.9% gain.

Costs up for banks

The Aussie market is up. Things must be looking good, right?

Not so fast. Not if the report in Bloomberg today is anything to go by:

Australian bank bonds haven’t been this expensive to insure compared to U.S. financial debt in more than a decade.

As the prospects for world growth have dimmed and global markets have been thrown into turmoil, Australia’s banks face additional risks including a reliance on offshore wholesale funding. They are also being buffeted by a housing market that’s showing signs of stuttering, the end of a decade-long mining bonanza and an economy that’s trying to adapt to slowing demand from China.

National Australia Bank Ltd. last week sold A$2.25 billion of three-year bonds in its home market at a spread of 98 basis points over the bank bill swap rate. That compares with 88 basis points for a similar tenor A$1.4 billion deal last month from Australia & New Zealand Banking Group Ltd. and 78 basis points for a A$2 billion Commonwealth Bank of Australia transaction in October.

Aussie banks have been the ‘golden boys’ of the market for so long it’s hard to remember when they haven’t been in favour.

Even in 2008 and 2009, despite everything that was happening around the world, the general feeling in the mainstream was that Aussie banks were safe — not like those ‘dirty’ foreign banks.

But that’s changing. As the Bloomberg report notes:

The average cost of protecting the bonds issued by the four largest lenders in Australia last week climbed to 29 basis points more than the mean for the current four biggest American banks, the widest gap on record in credit default swap prices stretching back to 2004…

In simple terms, it means that, even though it may be unlikely that an Aussie bank will go bust, foreign investors aren’t taking any chances.

They want a bigger return on their money when it comes to yields, and the cost to buy ‘insurance’ against an Aussie bank default is rising. That suggests investors believe the risks are higher than they once were.

It’s not just Aussie banks, either. The Financial Times reports:

The biggest US banks are bracing for a tougher round of stress tests from the Federal Reserve, which could crimp their plans for higher dividends and share buybacks.

The two-part exam, which became an annual event in 2011, is designed to assess whether banks have enough loss-absorbing capital to keep trading through a shock to the system similar to the collapse of investment bank Lehman Brothers in 2008.

Of course, it’s a mistake to think that the banks live in an isolated world.

The banks aren’t looking bad just because there’s a problem with the banking system. The banks are looking bad because there’s a problem with the whole global economy.

Is it over?

But how can that be? The world is on the road to a recovery…that’s why the US Federal Reserve raised interest rates last year for the first time since 2006.

If only that were so.

As my colleagues and I have tried to explain for several years, the recovery was, and is, illusory.

If an economy is genuinely recovering, it doesn’t need interest rates near zero.

If an economy is genuinely recovering, it doesn’t go into apoplexy at the fear of a teeny-tiny 0.25% interest rate rise.

No. If the recovery or boom is genuine, or it’s at least self-sustaining, the market will look past the interest rate rise.

The market will say that the interest rate rise is proof that the economy is doing well.

But, that’s not how it is.

The best chart we’ve found to explain this is the Baker Hughes United States Oil and Gas Rotary Rig Count. Here’s the chart below:

Source: Bloomberg

According to this index, the rig count, last updated on Friday, now stands at 514. That’s down from 541 the week before, and down from 698 on 1 January.

Even worse, it’s down from 1,925 on 5 September, 2014.

This is why the banking system in both the US and Australia is in trouble right now. All those dollars from commodities producers, which used to flow in and out of the producers’ bank accounts, is now only flowing one way — out.

And it will keep flowing out until as many of the marginal oil producers as possible can no longer afford to drill.

When that happens, it will start to impact supply, and that should at least stabilise the oil price — if not push it higher.

Remember, what’s the cure for high prices? That’s right, high prices. It draws in more producers, which in turn increases production and smashes down the price.

On the flipside then, what’s the cure for low prices? That’s right, it’s not a trick question; the answer is low prices. It forces producers to keep producing, hoping that they can get as much cash flow as possible from operations.

But, eventually, the low price kills them. Has the market reached that point yet? It doesn’t look like it, but it may not be far off.

However, that doesn’t necessarily mean that it’s time to buy oil yet. Odds are, before things get better, they’re going to get worse.

This chart showing the number of distressed bond issuers still has a little way to go before it reaches the 2008 level:

Source: Bloomberg

Once it takes out that high, then it may be a sign that the worst is over…maybe.

Until then, oil companies, banks, and any other sector you care to mention, beware.


End of day market data

If you have any ideas about what you would like us to include in our end of day market data drop us a line at letters@portphillipinsider.com.au, and type ‘Market data’ in the subject line.

52-week highs: 24 stocks, including Hunter Hall International Ltd [ASX:HHL], Hansen Technologies Ltd [ASX:HSN], and The Reject Shop Ltd [ASX:TRS].

52-week lows: 28 stocks, including EQT Holdings Ltd [ASX:EQT], Reckon Ltd [ASX:RKN], and Tower Ltd [ASX:TWR].

Note: The stocks listed above are stocks that hit an intra-day 52-week high during today’s trading. The stocks didn’t necessarily close at the 52-week high.