Yield Curve Flattens JPMorgan's Expectations

 | Jul 14, 2017 | 3:00 PM EDT
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JPMorgan Chase's (JPM) second-quarter conference call gave Wall Street a taste of CEO Jamie Dimon's colorful choice of words, but it also gave an important update on the company's outlook for 2017. 

The key number to focus on, as with any money-center bank's earnings, is net interest income (NII). JPM's NII grew only $200 million in the quarter, about half of the $400 million quarter-over-quarter growth CFO Marianne Lake had forecast on JPM's first-quarter conference call. As a consequence, JPM is now guiding to $4 billion of growth in NII for full-year 2017, down from the $4.5 billion management had expected in April. 

Net interest income is a constantly moving target for a global banking behemoth like JPM, but Lake did highlight the key factor hindering JPM's NII growth: a change in the alignment of interest rates. It's that frustratingly flat yield curve. Again. I have harped on the flatness of the yield curve in several Real Money columns, and I use the industry standard for measuring the curve itself; the spread between the yields on the two-year and 10-year U.S. Treasury notes. 

The 2-10 spread sits at 97 basis points as of this writing, down significantly from the 110-130 basis-point range that prevailed in the first months of 2017. Yes, the spread has rebounded somewhat from the recent low of 81 basis points registered on June 23, but these are very low levels by historical standards. The most fundamental metric for a deposit-taking institution is the spread between what it pays out in deposits (short-term by nature) and what it charges to make loans (long-term by nature). So when the spread narrows, it puts pressure on banks' NII. 

JPM shares' torrid run since the election of President Trump has put their valuation at cycle highs and ratios that I have trouble comprehending for a company that is still -- as diversified and exposed to different sectors and geographies as JPM is -- at the end of the day, a bank. In today's trading, JPM shares are fetching 1.72 times the second quarter's tangible book value of $53.29. That price/book ratio almost seems like a typo to me, and the fact that JPM shares haven't fallen more today on management's negative outlook for NII makes me wonder if the shares are indeed bulletproof, or to use Dimon's favorite term, "a fortress." 

A look at history shows, however, that JPM, like all bank stocks, is vulnerable to changes in the term structure of interest rates. I built the spreadsheet below today using data from JPM's second-quarter earnings release data for the past six years. JPM's tangible book value has grown in each period, although the rate of growth has slowed, and return on tangible common equity has been steady near 14%, still lagging the 17% achieved earlier in this economic cycle. 


As the spreadsheet shows, JPM shares put in brilliant performances in the one-year periods ending in July in 2017, 2015 and 2013. Yet the shares performed poorly in the July-end fiscal years of 2016, 2014 and 2012. It's not some odd-even numerology at play, it's the 2-10 spread and the relative valuation of JPM's shares. In the years the 2-10 spread widened (the odd ones), JPM shares saw a meaningful increase in the multiple of tangible book value, and the shares outperformed. Years with 2-10 spread compression also saw JPM's price/tangible book ratio compress, and thus the shares were laggards. 

Much like the equity market, the government bond market is a forward-looking discounting mechanism. Unlike the stock market, however, the bond market has already priced away much of the Trump Jump euphoria of early 2017. It is clear that Lake and Dimon are concerned about a flattening yield curve (hence the lowered guidance) and JPM shareholders should be concerned about the stock's recent history during such periods. 

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