With big banks kicking off the all-important third quarter earnings season this [past] Friday, what they report – top line, bottom line, and everything in-between – really matters. Put simply, they’re the best market bellwether right now.

Here’s why: The state of big banks – where they’re making money or why they’re not making tons of money – will tell us about businesses, consumers, and trends, which the stock market will then trade off of.

Anyone who isn’t paying attention is going to miss the next market shift and lose out on opportunities to make money no matter which way it goes.

But let’s get one thing out of the way right up front: don’t expect much in terms of upside surprises in earnings reports. While there are some areas where we might see positives, the impact of rising interest rates is pretty predictable – in fact, it wouldn’t surprise me if banks’ results are worse than expected and they guide cautiously, or negatively.

Let me explain why, what to expect, and how to trade the news.

The Tale of the Tape
First off: bonds.

Bond issuance, IPOs, mergers and acquisitions, the investment banking business in general, has been slow. Even dead, in some instances.

Bond issuance in Europe saw 32 days so far this year with not a single issuer, government or corporate, floating any new debt.

According to data from the Securities Industry and Financial Markets Association, high-yield and investment-grade bond issuance in the U.S. fell 26% in the first half of 2022 compared with a year ago.

It’s worse for equity issuance. On the heels of 2021’s record-setting pace of initial public offerings (IPOs) priced on U.S. exchanges, IPO activity dropped sharply in the first half of 2022. In 2021 a total of 1073 companies IPO’d, raising $317 billion. In the first half of 2022 the total was just 92 companies, raising less than $9 billion, according to Factset.

Mergers and acquisition (M&A) volume this year is down 63%, looking at Dealogic data.

FICC (or fixed income) commodities and currency trading is one area that could go either way. While bank trading desks – in fact, all professional trading desks – love volatility and generally make a ton of money in volatile markets, especially if there’s a defined trend, this year and the third quarter in particular may be different.

Fixed income – meaning bonds and packaged bond-like products including mortgage-backed securities (MBS), asset-backet securities (ABS), and bond derivatives – have seen unprecedented volatility this quarter. While the trend has been down, there has also been a tremendous amount of big daily down moves and up moves that traders could have been whipsawed by. The same’s true with commodities.

This is twice as true when it comes to currency trading, though there, the trend’s been obvious.

As slow as it’s been on the corporate client front, and impactful on the trading side of FICC, the same is true on the residential mortgage side. It’s not just slow, it’s dying. The opposite is true on the consumer credit side – that’s been exploding in a frightening direction due to rising rates.

There’s no mystery why this is happening in the residential mortgage origination and refinancing business. When rates go up, business slumps. But when rates go up this fast and look like they’re going a lot higher, business dies.

Thirty-year mortgage rates went from just below 3% at the end of last year to around 6.85% now. That’s a 128% jump in mortgage rates. A year ago, a monthly payment of $2,000 could have gotten you into a $500,000 house. Today, that same monthly payment would get you into a $375,000 house.

That’s why banks’ mortgage business is dying.

Wells Fargo, still among the biggest players in mortgages, is surely about to announce layoffs in that division. Other banks have already started paring costs and personnel.

But it’s the consumer credit business that investors have to watch out for this reporting season. It’s been growing exponentially for banks, but it’s also about to backfire on them.

The Federal Reserve Consumer Credit G.19 report, referenced in the October 7, 2022 issue of Forbes, shows US consumer credit outstanding at $4.7 trillion. Since Q2 of 2011 through Q2 2022 credit increased 90%. And it’s been increasing of late. It jumped 6% in July and skyrocketed another 8.3% higher in August. September’s numbers haven’t been tallied yet, but they’re likely to show another jump.

What’s bad for banks is that those same consumers’ savings are dwindling back to below pre-pandemic levels.

The savings rate, measured as a percentage of disposable income, averaged 8.85% from August 1959 through August 2022. After spiking during the pandemic to 33.8% in April 2020, down to 20% in January 2021, it’s now down to 3.5%, well below the long-term average and 83% below where it was a year and a half ago. That’s already impacting consumer payments.

In Q2 this year, Bank of America, JPMorgan, Citi, and Wells Fargo began setting aside “loan loss reserves.” A recent analysis by Bloomberg estimates they’ll all have to set aside at least $4.5 billion this quarter.

As banks add to their loan loss reserves, it not only hits their current quarterly earnings, but it also sends a message to investors in bank stocks that they’re not so optimistic about future NPLs, or non-performing loans.

So the numbers at all levels matter here.

What banks’ top lines (aka their revenues) say about the general trend of their businesses is important. But not as important as what their bottom lines say about their profitability. And neither of those metrics are as important as what all the in-between numbers say about how businesses, consumers, and the economy are doing and likely to do going forward.

If big banks report disappointing numbers and guide conservatively, if not negatively, this quarter, investors are likely going to respond by dumping their stocks, selling other positions, and taking equity benchmarks to new (even lower) lows.

That’s how I see it, and that’s what we’re positioning for in my subscription services.

We’re buying puts and put spreads on banks who are the most over-exposed to consumers and international woes in the space.

You should do the same.

— Shah Gilani

Source: Total Wealth