Investors are taking risks again, fueling a surge in market activity and prices that is helping some Wall Street trading desks make more money.
However, analysts and traders warn, that the "Great Risk Rally of 2012" won't be the goose that laid the golden egg for Wall Street -- at least not in this quarter.
"It looks like we stepped away from the edge of the abyss," said Bill Stone, chief investment strategist at PNC Asset Management. But even as prices for stocks, bonds, commodities and certain derivatives have climbed since the end of 2011, overall trading volumes remain low.
And surging demand for fixed-income products has led to tighter spreads -- meaning broker-dealers earn less money on trades because there is little wiggle room on pricing.
"This quarter is a good but not great quarter" so far, said Glenn Schorr, a bank analyst at Nomura. "Definitely better than second half, but not as good as first quarter last year."
In addition to light volumes and tight spreads, sharp declines in investment banking activity will also hurt profits.
M&A volume is down 38 percent so far this year compared with the same period a year ago, according to Thomson Reuters data. Equity and debt underwriting volumes are both down the same amount, as are loans.
JPMorgan analyst Kian Abouhossein expects Wall Street banks to report a 13 percent decline in revenue for the full quarter, compared with a year ago, with fixed-income trading revenue down 13 percent, equities trading revenue down 15 percent and investment banking revenue down 16 percent.
"You have not seen a big volume improvement at all, which is a bummer," says Schorr.
Graphic: Wall Street hunts for profit growth
To be sure, investors are buying up equities and a wide range of fixed-income investments, from investment-grade corporate paper to junk bonds, emboldened by aggressive steps the U.S. and European central banks are taking.
The European Central Bank has loaned more than 1 trillion euros to banks since December, while the Federal Reserve has pledged to keep short-term rates low until 2014. Those moves have a two-fold effect: creating liquidity and forcing investors to hunt for higher returns elsewhere.
Confidence that Greece will receive a second bailout and signs that the U.S. job market is recovering also have strengthened market confidence.
"A lot of the rally is coming away from the really deep worries about the euro zone at the end of last year," said Stone at PNC Asset Management.
Higher prices not only reflect more trading, they are good for Wall Street because banks can earn more from asset-management fees and write-ups on giant securities portfolios.
The rally also suggests a recovery in investor confidence, which sets the stage for investment banking businesses like mergers and acquisitions to recover.
The impact will become more visible next week, when Wall Street earnings kick off with Jefferies Group Inc JEF.N results Tuesday.
Analysts predict the midsized investment bank, whose quarter ended February 29, will report earnings of 29 cents per share, according to Thomson Reuters I/B/E/S. That would be down from 42 cents per share in the year-ago period, but up from 21 cents per share in the fourth quarter.
Because larger Wall Street rivals Goldman Sachs Group Inc (GS.N), Morgan Stanley (MS.N), and the investment banking units of JPMorgan Chase & Co (JPM.N), Citigroup (C.N) and Bank of America (BAC.N) will include March in their first-quarter results, their earnings may be better.
Analysts predict that Wall Street's biggest investment bank, Goldman Sachs, will earn $3.03 per share this quarter.
That figure has risen in recent weeks as analysts adjust their estimates, and it may be tweaked further before Goldman reports results. However, the current estimate would be down from $4.38 per share in the year-ago quarter when excluding special items and up from $1.84 in the previous period.
Analysts predict Morgan Stanley will earn 44 cents per share for the first quarter, down from 50 cents per share a year ago, but better than the 15-cents-per-share loss it posted in the fourth quarter.
FOCUS ON NEAR-TERM
It is unusual for investors and analysts to put more weight in consecutive quarterly results than year-ago comparisons -- particularly for investment banks' first quarter, which tends to be much stronger than the holiday-laden fourth quarter.
But because the past 17 quarters have seen sharp swings in investment banks' profitability -- with rallies quickly fading into fresh crises -- a year ago seems like a distant realm. And because the market was riddled with fear about the solvency of European states and the health of European banks through late-2011, there has been a huge relief rally in the stocks and bonds of Wall Street banks.
Shares of Goldman Sachs have risen 29 percent so far this year, closing at $116.99 on Monday, while Morgan Stanley's stock is up 20 percent, closing at $18.20. The NYSE Arca Broker/Dealer Index has climbed 22 percent year-to-date.
"Everyone was worried about a Lehman 2.0 last year, but that didn't happen," explains PNC's Stone. "Now that things have stabilized, and the markets and economy seem to be on firmer footing, banks are benefiting."
The broader market also has jumped. The S&P 500 Index has climbed 9.5 percent this year, closing at 1,377.50 Monday. The Bank of America-Merrill Lynch High Yield Master II index of U.S. junk bonds has risen 5.2 percent, while Markit indexes that track credit default swaps on European bank debt have plunged 30 percent.
Strong demand for the Fed's sale of $19.5 billion worth of subprime mortgage-backed securities initially owned by American International Group Inc (AIG.N) also show how much investors have been craving yield. The Fed was able to reap a net profit of $2.8 billion on the sales, which had heavy bidding from half a dozen investment banks on behalf of clients.
Yet, oddly enough, that relief rally may actually hurt investment banks' bottom line.
Because of an accounting quirk known as debt valuation adjustments, or DVA, some banks may face significant charges related to improvements in their own bond prices. That's because companies are required to reflect changes in the cost of buying back their own debt.
Debt valuation adjustments tend to run parallel to changes in the price of credit-default swaps, which bond investors and counterparties use to hedge against risk of a financial firm not making good on its obligations.
Last fall, the price of such protection had soared as high as $420,000 a year per $10 million worth of debt for Goldman and as high as $584,000 a year for Morgan Stanley. As of Tuesday morning, the prices had fallen to $243,000 per year and $325,000 per year, for $10 million worth of each bank's bonds, respectively -- a 25 percent decline for each.
While analysts tend to exclude such gains and losses from their estimates, debt valuation adjustments have caused large swings in some banks' earnings in recent years, as market rallies quickly faded into new crises.
For instance, Morgan Stanley reported $3.6 billion worth of debt valuation gains in the last half of 2011, as its credit default swap prices more than doubled. The bank is likely to report a charge of hundreds of millions of dollars in the first quarter if its bond and CDS prices remain stable, analysts said. Goldman hedges its debt valuation risk, so its gains and losses are smaller and harder to predict.
For their part, Wall Street traders are hopeful that the rally will last.
(Reporting By Lauren Tara LaCapra and Carrick Mollenkamp; Editing by Alwyn Scott, Bernard Orr)