Does yield curve flattening hurt US bank stocks?

Summary

- US banks derive part of their income from borrowing funds and investing them, with interest rates paid and earned being correlated with the short and long ends of the Treasuries yield curve.

- Since the short end yields (for Treasuries) tend to be lower than the long end yields, usually US banks benefit financially from the difference.

- Given this, one would expect bank stocks to be strongly and positively correlated with yield curve steepening; i.e., the opposite of flattening.

- If we look at data from the past 5 years, however, the opposite has happened. As the yield curve has flattened, bank stocks have gone up.

Yield curve flattening and US bank stocks

US banks derive part of their income from borrowing funds and investing them, with interest rates paid and earned by the banks being correlated with the short and long end of the yield curve. Since the short end yields (for Treasuries) tend to be lower than the long end yields, usually US banks benefit from the difference. Given this, one would expect bank stocks to be strongly and positively correlated with yield curve steepening; i.e., the opposite of flattening.

The figure below shows, at the top, the difference in yields for 10-year and 3-month Treasuries for the past 5 years. The two graphs at the bottom show the stock prices for two banks: JPMorgan Chase, representing multinational investment banks; and U.S. Bancorp, representing regional banks. The sources for the graphs are Yahoo Finance and the US Federal Reserve Economic Data (FRED) (, ).

As you can see, prior to COVID there seems indeed to be a correlation between US bank stocks and yield curve flattening. However, it is the opposite of what we would expect. The correlation is negative. As the curve flattens, bank stocks go up. In other words, US banks tend to do well in response to what could be seen as a major obstacle to profitability.

What is happening? Compensatory adaptation

As the yield curve flattens, US banks react in a compensatory way – e.g., by resorting to other sources of income. This is compensatory adaption theory at work (, ).

Compensatory adaptation of this type is facilitated by the size and flexibility of the US economy. This makes the environment in which US banks operate significantly different from those of Japan and Europe, where arguably banks have fared worse.

Cold weather and COVID: Compensatory adaptation may lead to unexpected results

Summary

- If COVID cases necessarily spike in cold weather, it would be reasonable to expect more lockdowns in countries, like the US, which are about to transition from warm to cold weather.

- These lockdowns would presumably have a negative economic effect, and likely a severe negative effect on equity prices.

- This post looks at data from Brazil and the US, and concludes that COVID infections may not be significantly influenced by the weather.

- The reason may be a compensatory adaption feedback loop – people adapt in a compensatory way.

- In fact, if compensatory adaptation theory is any guide, it would not be surprising to see COVID infections actually go down, as a country with growing COVID infections transitions from warm to cold weather.

Do COVID cases spike in cold weather?

If COVID cases necessarily spike in cold weather, it would be reasonable to expect more lockdowns in countries, like the US, which are about to transition from warm to cold weather. These lockdowns would have a negative economic effect, and likely a severe negative effect on equity prices. But is it inevitable that COVID cases spike in cold weather?

To answer this question, it may be instructive to look at COVID figures for Brazil and the US, because these two countries have had similar responses to the pandemic (); and have opposite weather patterns – when it is hot in the US, it is cold in Brazil, and vice-versa. This applies particularly to the most populous areas of the two countries.

COVID figures for Brazil and the US

At the time of this writing, we had the following approximate numbers for Brazil and the US. Brazil – population: 209.5 million, COVID cases: 4.12 million, and COVID deaths: 126 thousand. US – population: 328.2 million, COVID cases: 6.26 million, and COVID deaths: 188 thousand. The two graphs below show the two following ratios: cases-to-population, and deaths-to-population.

The ratios are too close to support the “spike hypothesis”

In the last several months since the pandemic hit both countries, it has been generally cold in Brazil and hot in the US. Given this, these ratios are too close to support the assumption that COVID cases spike in cold weather. So, what would be a reasonable answer to the question posed earlier: do COVID cases spike in cold weather? The answer is: probably not.

What is happening? Compensatory adaptation

This brings to mind another question: would indoor activities, such as restaurant dining and movie theater attendance, lead to spikes in COVID cases?

Well, the idea was that cold weather would lead to more indoor activities ...

While risk of infection may go up with cold weather and more indoor activities, people react in a compensatory way – e.g., by wearing masks, resorting to social distancing etc. This is compensatory adaption theory at work (,). This feedback loop may lead to unexpected results.

If we use compensatory adaptation theory as a guide here, it would not be surprising if COVID infections were to go down, as a country with growing COVID infections transitions from warm to cold weather.

The business media is missing this: The rise of the immune

Summary

- The fastest growing “demographic” in the world today are those who are immune to COVID-19.

- This is bullish for equities, because those who are immune to COVID-19 are likely less hindered as consumers than those who are not.

- The equities that should benefit the most are those for companies at the epicenter of the pandemic.

- Why is the non-immune view the prevalent one in the business media? Probably because of the average age of those speaking and writing.

- The rising immune population so far is predominantly young.

The fastest growing demographic

The fastest growing “demographic” in the world today are those who are immune to COVID-19. At the time of this writing, there were 3.3 million confirmed cases in the US alone. Assuming that the actual cases are around 10 times the confirmed cases, we have 33 million cases in US.

If we consider the death rate to be 1 percent, this means that we will have about 30 million people with immunity to COVID-19 in the US very soon. Many are already immune. Even without a vaccine and some mitigation (e.g., masks), by the end of the year the number of immune people in the US could be 100 million. In the world, this number could be 500 million.

People want the immune around them

Herd immunity is seen as a desirable goal because of the idea that the immune form a protective barrier around the non-immune (). In this sense, immune people are a better barrier than social distance. For example, if you have an immune person in between two non-immune people, that may be better than six feet of empty space. The immune person is much more lethal to the virus.

High-risk individuals, such as the elderly, are advised to isolate themselves. However, social and physical isolation could negatively affect their health in various ways unrelated to COVID-19. The real problem is interaction with the non-immune, because of the risk of infection. Interaction with the immune is fine. Maybe more than fine, because of the benefits of social interaction, not to mention needed care. People will want the immune around them.

Media naturalness theory

With current commercial technology, virtual meetings are simply not a viable alternative for a species that evolved over millions of years communicating face-to-face. The naturalness of a communication medium (i.e., how similar it is to the face-to-face medium) leads to a number of effects. For example, low naturalness reduces physiological arousal. Also, low naturalness leads to more confusion, particularly when knowledge is being communicated ().

So, face-to-face meetings will be needed, particularly when knowledge-intensive tasks must be carried out. Imagine a non-immune person being asked to attend a face-to-face meeting with 5 other people, all using masks. Would that person like the idea of the meeting more if she knows that all of the 5 other people are immune? Probably yes. Maybe not 5, but 3. The more the better. Again, people will want the immune around them.

Businesses will want the immune

Airlines are being asked to keep middle seats empty. Imagine you getting on an airplane and going to your window seat, just to find out that someone is sitting next to you, in the middle seat. You do not like it, even though the person is wearing a mask. He tells you that he is immune, and shows you the results of an immunity test. Will that make you feel better? Probably yes.

Companies that are at the epicenter of the pandemic are airlines, bars, restaurants, amusement parks, and ride-sharing companies. All of these companies have a strong incentive to have the immune as their employees, partners, and customers. Would a non-immune person favor a bar where most customers are immune? Probably yes.

Is this bullish for equities? If yes, what equities?

Arguably this is bullish for equities, because those who are immune to COVID-19 will probably be less hindered as consumers than those who are not. It stands to reason that the equities that should benefit the most from this are those for companies at the epicenter of the pandemic. Essentially, the ones that suffered the most so far.

Virtually all of the discussion in the business media nowadays is from the standpoint of the non-immune. One hears things like: “… the consumer will be cautious going forward … the risk of infection …”, “… parks will never have the same sales again …”, “… the economy will never be the same …” etc. Think about these statements assuming that you are immune – they make little sense.

And the numbers of the immune are growing fast, even without a vaccine. They will grow a lot faster with one or more effective vaccines. Also, keep in mind that the immune are not only consumers themselves, but also enablers of consumption. For the economic recovery, they are worth their weight in gold!

Why is the non-immune view the prevalent one in the business media? This may be due to the average age of those speaking and writing.

The rising immune population now is predominantly young.

Data from China suggests that economic activity could resume after initial containment and not trigger new COVID-19 cases

Summary

- A study was published in early 2020 by Ainslie and colleagues (), suggesting that, after initial containment is achieved, within-city movement (measured through a “Movement Index”) seems to be uncorrelated with new COVID-19 cases.

- Within-city movement is used in the study as a proxy for economic activity.

- Economic activity seems to have successfully resumed within approximately 2 weeks from containment, and approximately 4 weeks from the peak of new cases.

Within-city movement vs. new COVID-19 cases

The graphs below summarize key results from a study published in early 2020 by Ainslie and colleagues (). Dr. Ainslie is in the Faculty of Medicine, School of Public Health, Imperial College London. The study looked at within-city movement, as a proxy for economic activity, and how that movement has influenced the numbers of new cases of COVID-19 in various areas, after initial containment.

As you can see, after initial containment is achieved, within-city movement (measured through a “Movement Index”) seems to be uncorrelated with new COVID-19 cases; or somewhat negatively correlated, as the authors note. This rather surprising and counterintuitive outcome may be due to people becoming much more cautious about social interactions.

Time to resumption of economic activity

Note from the graphs that economic activity seems to resume within approximately 2 weeks from containment, and approximately 4 weeks from the peak of new cases.

Also note that containment has been fairly effective in China. The Chinese government has enforced it through strict lockdowns. Perhaps this is what makes people so cautious about social interactions afterwards, which we speculate might be at the source of the success of their strategy.

From an economic revival perspective, these are good news – particularly if the same approach can be replicated in other countries and regions.