Macaskill on markets: FICC bonanza could soon be but a fond memory


Jon Macaskill
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It’s the year that just keeps giving for fixed-income traders. But the growing intensity of the race to exploit this state-sponsored boom suggests that there will be significant disruption when the FICC festive season ends.


Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks

Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks

Goldman Sachs might well hit $25 billion of revenue for the year in its fixed-income, currency and commodities (FICC) group. JPMorgan could come close to $20 billion of comparable revenue and even beaten-down Bank of America and Citi will be at similar levels if they can avoid fourth-quarter trading mishaps.

FICC sales and trading revenues of roughly $100 billion for the biggest eight players in the first three quarters of 2009 dwarfed comparable equity and corporate finance income. The seasonal downturn from second- to third-quarter revenue was less pronounced than usual for the leading players and fourth-quarter flows are anecdotally healthy. But the dual effects of reduced government support and increased dealer competition threaten to undermine this bonanza in 2010.

Mohamed El-Erian and Bill Gross of bond fund Pimco have spent this year relentlessly promoting the idea of a New Normal era in the wake of the crisis of 2008. The defining features of their New Normal are lower growth, deleveraging and re-regulation. The past 12 months inevitably saw the first two of these phenomena, but governments struggled to reach a consensus on re-regulation. Global banks skilfully exploited national paranoia about the potential effect of hasty change on local markets to slow a dash to re-regulation that had seemed inevitable at the end of 2008.

The key global supervisory consensus was the flipside of this fear of unintended consequences from re-regulation: every major central bank felt bound to keep interest rates close to zero to avoid discouraging economic recovery.

The combination of an effective guarantee of interest rate levels and government purchases of debt created an almost perfect trading environment for dealers.

Bid-offer spreads were wide in a host of formerly liquid instruments at the beginning of this year across rates, credit, currency and commodity markets. After dealers led by Goldman Sachs drove their trading trucks through these spreads in the first quarter a number of analysts predicted that the boom would prove temporary. A return of competition and narrower absolute spreads for credit products would ensure that these revenues were unsustainable, according to this analysis.

This call will eventually prove to be correct, even if it is premature.

Goldman Sachs generated $6.56 billion of FICC revenue in the first quarter, which was 34% higher than its previous record for the period. It was able to follow this up with $6.8 billion of second-quarter revenue – a record for any three months – then $5.99 billion in the third quarter.

Goldman changed its calendar for quarterly reporting after its emergency conversion to bank holding company status last year. This distorts comparisons but there are precedents for a strong late-year FICC performance. Goldman saw a dip of 32% from the third to fourth quarters in 2007 but in 2006, the last full year of the Old Normal before the credit crisis unfolded, FICC revenue rose by 9% from the third to fourth quarters.

That augurs for a 2009 annual total for FICC revenue of about $25 billion at Goldman.

JPMorgan has also maintained FICC momentum this year. The bank said after posting $5 billion of third-quarter fixed-income revenue that it expected markets revenue to normalize. That could reflect a longstanding tendency by chief executive Jamie Dimon to attempt to underpromise and overdeliver. JPMorgan generated $14.8 billion of fixed-income markets revenue by the end of the third quarter, which was almost identical to the $14.9 billion produced by its entire investment banking operation in the same period in 2007.

But JPMorgan’s cautionary note about the prospects for sales and trading revenues was echoed elsewhere.

Most firms characterized credit, rates and foreign exchange trading in the third quarter as strong, while acknowledging that lower spreads were inevitably starting to affect margins.

The language used in recent bank results announcements and investor presentations reflected conflicts between a desire to accentuate the positives of the current FICC boom and a degree of realism.

Barclays Capital adopted a buzzword in vogue among analysts by stating at its last results that it wants to be a "flow monster and not a proprietary shop". This approach conveniently suggests both a degree of permanence for trading-based revenue and a reason for consistently underperforming Goldman Sachs, which is always presumed to have greater reliance on proprietary revenues than any of its rivals.

The two other reigning European fixed-income flow monsters – Credit Suisse and Deutsche Bank – have also stressed the joys of liquid product trading this year.

Credit Suisse attributed a 21% decline in fixed-income trading revenues from SFr3.1 billion to SFr2.46 billion ($2.44 billion) between the second and third quarters to lower volatility in rates products and a seasonal dip in demand. It asserted that it still had a significant opportunity to gain market share in global rates and foreign exchange, however.

This conviction appears to be shared by a growing number of other dealers, which points to further margin compression in 2010.

UBS set out a roadmap for recovery in mid-November. A planned investment banking comeback is largely predicated on anticipated fixed-income revenues. UBS targets SFr8 billion or more of annual FICC revenue from 2010, a third of the amount Goldman will achieve this year, and around two-thirds of the likely 2009 total at national rival Credit Suisse.

UBS is building much of its new-look FICC franchise from scratch, having gutted its old debt sales and trading business during 2007 and 2008. This will entail a dash for growth by relatively newly recruited staff and the fastest way for this approach to succeed is by attacking the margins of more-established competitors in liquid markets.

US banks intent on winning back market share from Goldman, JPMorgan and the European big three in FICC also seem to have concluded that an assault on margins in liquid markets is required.

Morgan Stanley has underperformed in FICC in 2009 after chief executive John Mack restrained traders from taking risk while other banks were riding the rally. The bank generated just $4.33 billion of fixed-income sales and trading revenue in the first nine months, less than 25% of Goldman’s total.

Mack – in a late-career burst of self-awareness – admitted he had been wrong and committed the bank to a push to improve sales and trading returns. Morgan Stanley will be joined by over a dozen other banks in this drive just as there is a heightened risk of significant fixed-income market dislocation.

The Federal Reserve is straining every muscle to convince the markets that core rates will remain near zero. It quietly promoted the idea that its November commitment to frozen rates was good for at least six months, then the president of the Federal Reserve Bank of St Louis mused that rates might remain unchanged until 2012.

But the Federal Reserve does not have to take away the interest rate punchbowl – the markets could overturn it. Various mini-bubbles are developing, including dollar-based FX carry trades and yield curve steepness plays within rates markets.

A spike in global interest rates – perhaps at the first sign of a fall in US unemployment – could expose the fragility of some of these relative-value plays, as well as the extent to which fixed-income results have been flattered by old-fashioned, unhedged, long positions.

Margin compression could also undermine the FICC boom, even if the main sovereign borrowers manage to convince investors to keep buying their debt. Aggregate single-A corporate spreads fell by more than 100 basis points in the third quarter and Baa spreads dipped over 150bp. Bid-offer spreads in liquid rates markets such as swaps, treasuries and Bunds are close to pre-crisis levels. And adoption of centralized clearing can be expected to exert downward pressure on derivatives margins.

Rival bankers extrapolating from Goldman’s 2009 results to conclude that there will be $130 billion or more of FICC revenue ripe for the taking in 2010 could be in a for a nasty surprise. 

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