Did JP Morgan foresee the taper tantrum?

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Banks used to be very much in the spotlight a decade ago as people wondered how they could grow to be so big . For example, JP Morgan’s total assets of $3 trillion USD is several times higher than Malaysia ‘s GDP.

However in the process of building our secret box, we will show precisely to think of banks and explain their mysteries .

(Note to self: No more culture war editorializing )


Interestingly in 2019, JP Morgan earned $84 billion in interest revenue from over $2.3 trillion in interest earning assets. Primarily, 60% of the revenue came from Loans.

More pertinently, the 60% contribution of total interest income to JP Morgan is primarily driven by US Loans. When we look at JP Morgan’s interest income contribution from its loan book, over 90% of the interest income contribution is from US Loans as compared to Non-US loans. For example in 2019, the interest income contribution from US loans was $48.0 billion compared to Non-US loans of $2.4 billion.

Actually, you can tell a big difference about what makes one bank different from another by examining its balance sheet and components of income. For example, JP Morgan’s loan income is almost all from US loans, which makes it a US bank. On the other hand, Citigroup will make a lot of its income from Non-US loans. Banks like Rabbobank, are a bit more specialized in agriculture lending and will make more of its income from such projects. Aussie banks on the other hand mainly make their income from gourging on Australian mortgages

You can argue its a zoo out there, but by understanding how these banks work, we can get a very good early indicator of how the economy is progressing.

The first step to understanding how Banks work is to look at the components of its interest income, which is related to its balance sheet. The first component is “Deposit with banks“, which accounted for 4.6% of JP Morgan’s total interest income in 2019.

So what exactly is this:

 

It is the interest JP Morgan earns from depositing money in other banks. But because of its size, literally the only bank JP Morgan would deposit its money with is the Central Bank, which could be Bank Negara in Malaysia, the Bank of England in the UK or the Federal Reserve in the United States.

 

Lets look at the above two charts. The first shows the amount of such deposits in these central banks, and the second shows the interest income JP Morgan earned from these deposits.

Quite strikingly, you notice that the interest income which used to amount to $1,448 million a quarter in the 4th quarter of 2018 got crushed to only $38m in the 4th quarter of 2020. At the same time, the volume of deposits shot up to almost $500 billion.  So just remember that interest income, comprises of 2 inputs – interest rate charged and the volume of deposits in the bank in the following mathematical relationship

Interest Income ($) = Interest Rate charged per annum * Volume of Deposits

But lets look at this thing differently.

Specifically we want to look at the relationship between 2 inputs, namely the Interest rate charged and the Volume of Deposits. 

Now you argue that there is no reason why these two should be related because the Interest Rate charged is determined by the Federal Reserve and the Volume of Deposits is determined by the Bank’s strategy.

Actually, it is precisely this reason which makes this relationship interesting.

We want to find out about stuff that is hidden namely, what was JP Morgan’s strategy in response to different interest rates. (This is the stuff people don’t talk about)

So interestingly we see this ‘funny’ kind of downward sloping line where for most parts, increased deposits result in lower interest rates.

Now, this relationship will not always hold true for all banks because banks differ from size. So a small bank may not exhibit any such relationship because it does not affect the economy. However JP Morgan’s asset size of $3 trillion US makes it a very good proxy to figure out how the Federal Reserve’s quantitative easing affects interest rates. (Note: A more accurate way is to model the Federal Reserve’s balance sheet)

So we see that towards the end of 2020, JP Morgan started moving hundreds of billions more to the Federal Reserve at much lower interest rates. In fact, it used to earn $1.5 billion a quarter on $350+ billion of deposit, but now it only earns $38M on over $500 billion of deposit. So why not just buy up all the US Treasury bonds out there and earn more money than just sitting on these low yielding bank deposits?

Is JP Morgan that stupid?

Ok, point 1: JP Morgan is not stupid. They are really smart.

Number 2, did you hear about all these stories recently about the US Yield Curve going bananas. If JP Morgan were to move all that money into the US Treasury bonds, they would get crushed if rates rose up quickly. So JP Morgan was smart – they took short term pain of low deposit rates in Central Banks but have unprecedented firepower if they want to convert this to Treasury bonds at higher interest rates. I mean, why buy $100 billion of US Treasury bonds at less than 1% yield when you can buy it at 2.5% yield in 1 years time? You literally make 2.5x your interest by timing this sort of game-changing moves.

Of course, not all banks may have been so wise as JP Morgan. Some banks may become short-term focused and moved all their cash to Treasury bonds at under 1% yields to get some better short-term earning boost.

When yields shoot up, these bonds lose value and these banks do not have any firepower.

Question is: Did JP Morgan foresee this taper tantrum?

That is why I think JP Morgan is very smart.

 

 


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3 COMMENTS

  1. So, JP Morgan not going kaput like what you wrote in April 2020? If only you invested in April USD90 and now Feb 2021 it is USD150.

    Kaput or not?

  2. Kind of sucks having to deal with trolls
    rembautimes.com/2020/09/22/why-jp-morgan-hates-negative-interest-rates/

    I am not into trading but into systems building

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