US bank earnings reports have not improved the market mood, with JP Morgan, Wells Fargo, and Goldman Sachs reporting a combined Q3 revenue of $83.6bn. Despite this, US equity market futures suggest a lower opening, and the Vix index has risen. Wells Fargo shares have increased in pre-market trading, Goldman Sachs shares are down 2%, and JP Morgan shares remain stable.

JP Morgan reported revenues of $47.1bn and a net income of $14bn but missed net interest income expectations. Analysts express concern over potential declines in net interest margins with five Fed rate cuts predicted by 2027. JP Morgan set aside $3.4bn for loan loss provisions, slightly above expectations, signifying that it can handle potential losses without destabilising the financial system.

Confidence in Customer Credit Quality

The bank maintains confidence in customer credit quality despite some weakness in the labour market. It highlighted strong performance in wealth management and other business lines, but CEO Jamie Dimon cautioned about risks from private credit markets and possible stagflationary pressures.

Wells Fargo plans for a 17-18% return on common equity, making it attractive due to its lower valuation compared to JP Morgan. Meanwhile, Goldman Sachs battles market pressures despite a 42% increase in investment banking fees and growth in trading and capital markets income.

The market is telling us to pay less attention to the strong headline earnings from the banks and more to the weak price action. A rising VIX, now hovering near 20, signals that traders are buying protection and anticipate bigger price swings in the coming weeks. This suggests that using options to hedge or express a view on volatility, rather than outright stock positions, might be the more prudent approach.

Looking Ahead to Interest Rate Cuts

We see the market is already looking ahead to the five interest rate cuts priced in by early 2027, which will likely squeeze the net interest income that has boosted recent profits. The latest data from the CME FedWatch tool shows a greater than 70% probability of the first cut by March 2026, reinforcing this view. This makes buying longer-dated put options on a broad financial index like the XLF an attractive hedge against future margin compression.

A clear pair trade opportunity has emerged from this earnings round, pitting the relative strength of Wells Fargo against the weakness in Goldman Sachs. Going long Wells Fargo while shorting Goldman Sachs could isolate their differing valuations and operational performance from the broader market malaise. This strategy allows us to capitalize on WFC’s attractive ROE guidance without being fully exposed to a potential sector-wide downturn.

Jamie Dimon’s warning about stagflationary pressures should not be ignored, especially as it aligns with recent economic data. Last week’s preliminary Q3 GDP came in at a weaker-than-expected 0.8% annualized rate, while the latest CPI print showed core inflation remains sticky at 3.5%. This backdrop supports positioning for downside risk in the broader economy through puts on cyclical indices like the Russell 2000.

This environment has echoes of what we saw in mid-2007, when strong bank earnings temporarily masked underlying risks before the market turned. The fact that solid results from JP Morgan provided an opportunity for investors to sell is a significant warning sign. It suggests that for now, the path of least resistance for the market may be lower, despite seemingly healthy fundamentals from its largest financial institutions.

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