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Will the moment of attack by a US version of "Yu'E Bao" on the banking industry come with the Fed's interest rate cut?

Hello everyone, Dolphin's strategy weekly report is here again. Based on new information, Dolphin has made significant adjustments to his views this week. The key points are:

1) In addition to the clear crisis of trust in the US banking industry, there is also a risk of continuous outflow of deposits due to the widening gap between current deposits and risk-free interest rates. In the situation where the asset yield rate of the banking industry stock is too low and the interest rate gap is too large, if the Fed raises interest rates and inflation is not eliminated as expected, the banking system may collapse first.

2) Based on new information and updated understanding, Dolphin adjusts his view: although it is not advisable to confront the Fed, the direction of the interest rate cut in this market game is likely to be correct. The 10-year Treasury yield may fall to a new range, such as 3%-3.6% fluctuation.

3) Based on this directional judgment of the interest rate cut: For equity assets, there is a similar logic to buying Hong Kong stocks at the beginning of the year for valuation repair. After the high interest rate is over, the US faces recession and liquidity risks, while Chinese assets are free from the "curse" of high interest rates and follow the logic of economic recovery, but the speed of recovery will be the main contradiction. Therefore, Chinese assets will have relative returns, but the ability to cash in after the repair of the fundamentals is more important. It is best to look for companies with relatively good fundamentals but not fully priced by the stock price for basic repair.

4) The portfolio yield rate last week was 2%, lower than the Hang Seng Technology Index, but slightly better than the Shanghai and Shenzhen 300 and S&P 500. In terms of restructuring, the portfolio last week sold out Pinduoduo as stated earlier, and Sunshine Power was sold out of new energy, while Micron was first included. For specific explanations, please refer to the text.

Here are the details:

I. Key disagreement: The Fed and the market are "fighting" again!

On the one hand, some banks are drowning, and on the other hand, real inflation is severe. The Fed's solution this time and its subsequent statements show that its solution is: to solve the pressing problem first, but the main task is still to reduce inflation, so high interest rates will still be maintained for a period of time.

  1. After determining that the bank has a liquidity crisis rather than a repayment problem (urgent but not as important as anti-inflation), the Fed did not pull the drowning bank ashore, but instead sent an oxygen delivery tube to the underwater bank.

  2. Continue to raise interest rates by 25 basis points, but consider the credit tightening effect caused by the bank's liquidity crisis.

  3. The prospect of subsequent interest rate hikes changes from "ongoing hikes are appropriate" to "some additional policy firming may be appropriate", which means that if a rate cut is needed later, this sentence paves the way for it.

In March, the market and the Fed did not disagree on raising interest rates by 25 basis points, but the key disagreement is in the comparison of the following two charts:

1) The Fed's expectation for the subsequent interest rate path is: another 25 basis points rate hike in May, and then maintain this interest rate for a whole year. By the end of 2023, the interest rate is still 5.1%, and by the end of 2024, it is still 4.3%.** 2) The expected path of the interest rate in the market is: there may be one more interest rate hike at most in May, and it is very likely to enter the interest rate reduction channel afterwards, and it will continue to drop to 4% by the end of the year, which is lower than the interest rate point predicted by the Federal Reserve after one year;

Note that this market expectation is still the implied interest rate hike/reduction path in the market after the March 22 interest rate meeting, following Powell's emphasis that interest rate will not be reduced within the year: Although the decrease in interest rate has slowed down compared to before the interest rate meeting , there is still a significant "directional" difference from the path guidance of the Federal Reserve without interest rate reduction.

Moreover, from the perspective of the expectation of the trading in the US bond market until last weekend, the market did not attempt to bridge this gap. Compared with the current US Federal Reserve daily interest rate of 4.83%, the market still believes that interest rate may be reduced within six months, and the question is not whether interest rate will be reduced or not within one year, but how much it will be reduced.

Although it has always been said "Don’t Fight against the Fed", this time the market seems to be fighting against the Federal Reserve again. But whether the Federal Reserve is "stubborn" or the market has foresight, which one will win this time?

Regarding the answer to this question, I have adjusted my view last week: I am increasingly inclined to believe that the judgment of the market on the magnitude of the interest rate reduction may need to be discussed, but the judgment on the direction of the interest rate reduction is likely to be correct, and the guidance of the Federal Reserve to not reduce interest rate before the end of the year may not be feasible in reality.

The reason for this judgment is that the transfer of the household deposits in the US this time (from small banks to large banks, and from within the banking system to outside the banking system) not only poses a trust crisis for the entire small and medium-sized banks but also a structural transfer driven by interest rate difference under the current high-interest environment. In other words, even if this trust crisis caused by the transfer is solved this time, as long as the interest rate continues to remain at a high level and the banking system does not quickly catch up with the deposit interest rate to the risk-free level, the outflow of deposits from the entire banking system is likely to continue and accelerate.

As can be seen from the figure below, the current interest rate of the savings account in the banking industry is only 0.37%, while the interest rate of one-month national bonds and interbank overnight financing without default risk is already around 4.7-5%. This inverse interest gap, under the high-interest and continuous period of the Federal Reserve, will lead to an increasing outflow of deposits if the banking system does not quickly catch up with such high liquidity risk-free assets with the savings interest rate.

As you can see, when deposits flow out quickly, banks can only increase loan amounts to balance their assets and liabilities. The year-on-year growth in recent lending has been at a level of 25-30 per cent.

In addition, in the case of accelerated deposit outflows, it is difficult for the asset side to match the liability side on a year-on-year basis. By the end of February, the first assets to experience a negative growth on a year-on-year basis were banks' cash assets and interbank borrowing, followed by fixed-income assets.

Moreover, in an environment of sustained high interest rates, the painful choice facing the banking industry is:

  1. If it does not quickly raise the interest rate on current accounts, depositors will only be able to fly southeast out of the banking system, to buy currency funds and short-term government bonds.

  2. If it raises deposit rates, according to the fourth-quarter operating results of the US commercial banking industry released by the US Deposit Insurance Corporation, the financing cost of the banking industry is only 1.17 per cent, while the asset yield rate (ROA) is only 1.12 per cent. Because the economy has been in a low interest rate society for a long time, the asset yield rate of existing assets is too low. Faced with such a high risk-free rate, the buffer zone is insignificant.

If the comprehensive financing cost of the banking industry (less than 1.2%) is really matched with the current risk-free rate on the market (5%), then the asset yield rate of existing assets is likely to be close to zero, if not negative.

Therefore, many of the fixed-income loans in the US banking industry, i.e. the pricing of front-end assets has not been matched with the market risk-free rate in real time, like the "LPR+ premium" in China's domestic banking industry, but has been priced according to fixed interest rates at that time (most of the mortgages on the balance sheets of the US banking industry are priced in this way, some of which may be adjusted every 10 years). When the financing cost of deposits and other financing rises, the asset yield rate will turn zero or even negative, and the bank's profitability will be almost zero.

If some real economy sectors, such as the currently highly concerned commercial office rental rate decline and default rate rise, are to squeeze bank profits in both directions, there may be a situation where loan assets have not yet defaulted.

Apart from the severe losses on fixed-income securities that have already been exposed, banks will also face the situation where the income from fixed-rate loans cannot cover the costs. The speed at which this situation occurs depends on how long the Federal Reserve will continue to raise interest rates and how long the high interest rates will be maintained.

The key reason why this whole scenario can occur is that the US has been in a low interest rate economy for too long without ever experiencing a 5% interest rate, which has resulted in the overall asset yield rate of banks' existing assets being too low. When interest rates rise so quickly and so high, and need to be sustained for a long time, the inevitable scenario that follows is an accelerated increase in financing costs. The US banking system simply cannot sustain such high interest rates that thoroughly and totally infiltrate their balance sheets. Even if new loans are issued prudently when deposits are lost too fast, it may be difficult to shrink their balance sheets to the same extent.

It is likely that the US banking system's balance sheet will falter before the Fed can eradicate inflation, which is reflected in the labor market approaching supply and demand balance. And the United States cannot afford the consequences of continuous bankruptcy in the banking industry. In the end, the Fed may have to lower interest rates. Perhaps the difference between the Fed's interest rate cuts and a US version of "Yu'ebao" is just a matter of time. After all, the current interest rate differential between current deposits and money market funds is too tempting. Once deposits flow out of the banking system rapidly, the Fed may be forced to lower interest rates to prevent a bigger storm in the banking industry.

II. Inevitable interest rate cuts, how to choose assets?

  1. Treasury yields: After the interest rate hike cycle, treasury yields fluctuate between 3.3% and 4%, floating near the midpoint of 3.5%. Therefore, in the short term after the interest rates hikes, treasury yields are likely to fluctuate between 3% and 3.7%, with the midpoint around 3.3%. When the problems of the banking industry and labor employment tensions intersect, there is still a chance for certainty the Treasury yields.

  2. High-yield ceiling: There is a logic similar to the valuation repair of Hong Kong stocks at the beginning of the year in terms of equity. After the end of high yields, there are recession and liquidity risks in the United States. Chinese assets no longer have the tight curse of high yields, and they will follow the logic of economic recovery, but the speed of recovery will be the main contradiction. Therefore, Chinese assets will have relative returns, but after the repair, the ability to cash in the fundamentals is more important. It is best to look for companies with relatively good fundamentals and insufficient pricing of stock prices for fundamental repairs.

III. Portfolio rebalancing

Last week, Alpha Dolphin adjusted the position of Pinduoduo. Even though it has an excellent long-cycle ability to outperform others in the e-commerce sector, the current valuation is too high and does not match the fundamental changes in current performance. The organization will wait for a more cost-effective pricing.

Yangtze Power was transferred out of the new energy sector. This mainly stems from the weakening of demand for photovoltaics in Europe and other places, and at the same time, Europe imposes restrictions on a single company's dependence. Meanwhile, the release of production capacity makes the competition in the industry worse. Therefore, when the stock price is repaired, the new energy position is reduced.

Micron Technology was introduced mainly because there is no problem in Micron's long-term logic. In terms of short-term cyclicality, US semiconductor stocks are gradually recovering, and the decline in risk-free interest rates is also relatively beneficial factor.

The specific portfolio is shown in the figure below:

IV. Alpha Dolphin Portfolio returns

During the week of March 24th, the Alpha Dolphin portfolio rose by 2%, slightly outperforming the S&P 500 (+1.4%) and the CSI 300 (1.7%), but lower than the 6.2% rise of the Hang Seng Technology.

Since the start of the portfolio test to the end of last week, the absolute return of the portfolio was 17%, and the excess return compared to the benchmark S&P 500 index was 26.2%.

5. China's asset-value ratio is highlighted amid the risk of decline, with a week of hype about Chinese concept stocks

Last week, under the macro logical inference mentioned by Dolphin, without the "tight curse" of an interest rate hike, China's assets as a whole still had an expected recovery. Both Chinese concept stocks and U.S. growth stocks had an enjoyable week, especially the former.

For companies with particularly exaggerated fluctuations in specific stocks, Dolphin has summed up the reasons as follows:

6. Distribution of Portfolio Assets

This week, the portfolio did not adjust its position, and it distributed 22 stocks, with 5 stocks still being rated as regular, an increase from 13 to 14 stocks with low rating, and the remaining stocks as gold, U.S. bonds, and U.S. dollars. As of the end of last week, the distribution of Alpha Dolphin's asset allocation and equity asset holdings were as follows:

7. Key Events of This Week:

This week, the fourth quarter financial report season is gradually nearing its end, with a focus on consumption and social service companies, such as Huazhu, Nongfu Spring, and Moutai, etc. In addition, there is also BYD, Kuaishou, and China Duty-Free. Specific areas of concern, Dolphin has summarized below:

Please refer to the following articles on recent weekly reports by the Dolphin Investment Research Team:

"Is the US Market Going to Recede or Reduce Interest Rates? In Any Case, Trade has Already Rushed Ahead."_

"The Runaway Crisis of Silicon Valley Bank: Is the US Recession Running?"

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"US stocks 'hitting back' at reality, how much longer can emerging markets bounce?"

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“Amazon, Google, Microsoft's stars falling? US stock 'meteor shower' still to come”

“Policy shift expectations: unreliable 'strong dollar funds' and GDP growth?”

“The moment of testing 'determination' for southern acquisitions vs northern runs”

“Slowing rate hikes? The American dream shatters once again”

"Reacquaint with a 'Iron-blooded' Federal Reserve"

"Sad Second Quarter: 'Hawkish' Voices Loud, Exodus Hard"

“When you fall into doubt and despair, is there still hope for a reversal?”





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