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FICC Could Benefit From Cyclical Sweet Spot – Jefferies

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FICC business could be entering a cyclical sweet spot over the next two years aided by rates and credit business, notes Jefferies in its recent research report.

Omar Fall and the team at Jefferies in their recent research report titled “Investment Banks – FICC is Dead; Long Live FICC” also point out structural headwinds must not be overstated.

FICC to benefit from rates revenues

The Jefferies analysts point out that rates revenues are positively correlated to a steeper yield curve and should recover as the path of central bank action clears. The analysts point out that there is a broad consensus expectation of a steepening US yield curve over the next two years as the Fed tapers its bond buying program, while fixing short term rates. The following chart depicts the relationship between a steeper yield curve and interest rate volatility:

Moreover, in terms of reported investment banking rates revenue, there is a clear relationship to industry volumes. Hence the analysts believe volatility and rates revenues are also correlated, as depicted in the following graph:

Volatiity and rates revenues

The Jefferies analysts thus believe a relationship can also be extrapolated between rates revenue and the steepness of the yield curve, as depicted in the graph below:

Rates revenue and yield curve steepness

However, the analysts point out 2013 has been an exception due to customer uncertainty around the quantum and pace of the withdrawal of QE. The analysts believe with the Fed’s path becoming clearer, a steeper curve should drive an upswing in revenues.

Benefit from credit business

They also believe credit revenues too are highly procyclical and should follow equities revenues in performing strongly in the medium term. The analysts point out that taper will also help, as QE has removed over $0.5 trillion of ‘tradeable’ MBS from the system in the last year alone.

The analysts forecast 6-7% clean FICC revenue growth over 2014-15 for the peer group, in-line with a return towards long term capital market growth rates of 8%. The following table captures the analysts’ forecasts:

FICC revenue forecasts

Structural headwinds

The analysts anticipate businesses representing no more than 10% of FICC revenues being impacted by market structure reforms, while the worst of deleveraging pressures should be behind the banks at end 2014. The analysts point out that structural headwinds including deleveraging and regulation are well anchored in consensus expectations and must not be overstated. Moreover, tailwinds such as disintermediation in Europe act as an offset while the analysts believe the ‘great rotation’ into equities is not an impediment to FICC performance.

Considering both consensus earnings estimates and valuations depressed by FICC exposure, the Jefferies analysts see significant upside to Deutsche Bank AG (NYSE:DB) (ETR:DBK) and Credit Suisse Group AG (NYSE:CS). The analysts have assigned a Buy rating on both the firms with target price pegged at € 45 and CHF 34 respectively. However the analysts assigned a Hold rating to UBS AG (NYSE:UBS) despite their successful restructuring story.

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