Investment banks play a major role in the functioning of markets. They take a sell orders, find buyers and profit off of being the middlemen in a variety of securities transactions, including stocks and FICC, the industry acronym for fixed income (bonds), currencies and commodities.
The industry’s revenue from trading is nowhere near the stratospheric heights it hit before the financial crisis. After 2008-2009, regulators took a harder line on bank risk-taking, crimping their ability to trade commodities and forcing Wall Street’s biggest firms out of the business of proprietary trading, or trading for themselves.
Still, last year had been shaping up to be a solid one as the effects of President Trump’s tax cuts kicked in and interest rates slowly began rising after years of being near zero.
December put an end to that, as U.S. stocks posted their worst year in a decade and their worst month since the Great Depression. A big chunk of fourth quarter’ pain came from violent end-of-year trading. It’s something analysts are calling “bad volatility.”
Trading benefits from day-to-day volatility. With prices moving up and down, speculators can bet for or against a variety of assets and make a profit. But traders weren’t viewing December’s sudden moves as an opportunity. Instead, many decided to stay on the sidelines, and trading “volume,” or the amount of shares or contracts trading at any given time, dried up.
“While ‘good’ volatility does generally foster greater market activity,’ bad’ volatility can keep market participants sitting on the sidelines until markets settle in,” Glenn Schorr, Evercore ISI analyst, said in a note to clients last week.
Schorr said he expected good and bad volatility to continue this year, benefiting stock trading more than bond trading.
Banks that focus on trading bonds such as U.S. Treasurys tend to fare worse in these periods because the business relies on using the firm’s balance sheet, Jeffrey Harte, equity research principal at Sandler O’Neill & Partners, explained. In order to buy or sell bonds for clients, banks often have to step in with their own money and buy and hold the securities first before finding buyers.
It’s easy enough to match buyers and sellers of blue chip company stocks. But bonds aren’t necessarily as quick to trade. As bond yields spiked the fourth quarter, and prices dropped, the value of banks’ holdings got hit. And when traders were paralyzed by uncertainty and sat on the sidelines, banks also lost out on trading fees.
“Even institutional investors weren’t sure what to do in December and sat on their hands instead of trading,” Harte, who covers the top investment banks, told CNBC.
An unresolved trade conflict with China, weakening global economic picture, and companies cutting profit forecasts all weighed on markets. In the bond markets, investors also went from thinking the Federal Reserve would raise interest rates three or four times in 2019, to expecting two hikes.
“A lot of the uncertainty really showed up in fixed income markets,” Harte said. “When you get a big surprise move in the Fed funds rate, even speculators and risk-takers say ‘I’m not sure what do here’.”