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Here's What Bank Earnings and Yield Curve Are Telling Us (Hint: Good News)

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Tuesday was busy, but the picture for markets came clear: Investors are taking incrementally more risk, at least for the moment.

After the large U.S. banks reported mixed earnings results, all three major U.S. stock indexes rose.

Let's go over what the financial market was telling us from a macro standpoint, and then we'll dive into what made investors so optimistic.

The Markets

The yield curve is no longer inverted. The 10-year treasury yield rose to 1.76% while the 3-month fell to 1.67%, creating a positive spread.

Investors were selling the 10-year, a longer-dated bond and an asset that's safer than stocks and other bonds, as they grew slightly more optimistic about economic growth and inflation.

Investors certainly moved into the 3-month treasury (yields fall as prices rise), as another Federal Reserve interest rate cut in 2019 is still expected.

But a lot of money also flowed into stocks. The S&P 500 rose as much as 1.09%, while the other major in indexes rose considerably. This was a classic risk-on day.

So what drove the optimism and risk appetite?

Bank Earnings

The results at the large-cap banks were mixed relative to Wall Street's expectations

But one theme encouraged investors who previously weren't holding bank stocks: The banks reported largely solid loan growth, which were aided by lower interest rates.

Wells Fargo (WFC) - Get Wells Fargo & Company Report reported Q3 mortgage-loan originations of $38 billion, better than the second quarter's $33 billion. The volume growth in home loans stemmed primarily from lower mortgage loan interest rates, Wells Fargo said in its earnings release.

Wells Fargo did miss earnings expectations, in part because of narrower net interest margins (2.66% v. 2.69% expected). That's the difference between what a bank takes in on loans and pays out on deposits. Low long-term rates usually pressure banks' margins.

JP Morgan (JPM) - Get JP Morgan Chase & Co. Reportbeat earnings expectations, but it also saw a very positive loan-growth trend. Credit-card, merchant-services and auto-service revenue climbed 9% year over year, "driven by higher card net interest income on loan growth," the company said.

The banking giant said its broader consumer-lending business benefited from "a favorable environment for borrowers, which helped drive healthy volumes in home lending and auto and strong loan growth in card."

What's Next

Lower interest rates, which the Fed has instituted in 2019, seem to be stimulating the economy. A considerable portion of the S&P 500's nearly 20% gain this year has been driven by low rates, and stock investors certainly wanted proof that the favorable rate environment is working.

That's why investors seemed optimistic Tuesday, operating on the assumption that slightly stronger economic growth and slightly higher inflation are ahead.

Still, the U.S.-China trade war, which has weighed on growth in several ways, is far from resolved and the risk of a recession beginning within the next 12 to 18 months has risen considerably.

Investors still expect a 73.2% probability of another 2019 rate cut. This would support equity prices, but some on Wall Street warn that the economic risks may outweigh the positive impact of lower rates.

Some strategists have said the S&P 500's current average forward earnings multiple of roughly 16.7 leaves the market fairly valued to slightly overvalued. 

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