What FOMC Meeting? Fed Stress Tests Show Stable Banks
The consternation over the Federal Open Market Committee meeting last week seems about as a relevant as yesterday’s papers. The week began and finished strong, with the S&P 500 twice touching a new all-time-high. Rates appeared greatly subdued by the sweet nothings whispered into its ear by the Fed. The market appeared to interpret the Fed’s activities as hawkish, however, as my colleague Brian Rauscher astutely pointed out as evidenced both by the dot plot and by public statements the majority of Fed governors are clearly dovish and will thus still be calling the shots.
Why is this important? The Federal Reserve is an extremely collegial body with a pretty unique way of doing things. The Chairman has a unique duty to listen to every governor intently, but there are a number of ways outlier opinions are subdued. The consensus-minded Chairman always has the unique power of setting the policy options at meetings and control of the agenda is a subtle, but powerful tool. The Fed Chairman, as far as financial markets are concerned, essentially has an even larger bully pulpit than the President of the United States in the majority of situations.
So, was the market’s interpretation of the Fed’s activity as more hawkish potentially incorrect? It is certainly a possibility, but of course the future is uncertain and only time will tell. We would postulate though that the Doves have been awfully quiet at a moment where it suits them to be. Last week’s announcement could be seen just as much in the context as a rear-guard action by the Doves to ensure they don’t lose their grip on the agenda.
The Dodd-Frank Act Stress Tests (DFAST) framework was created after the Global Financial Crisis and has since evolved into one of the most important and publicly visible elements of the Fed’s often overlooked supervisory function. The banking system is quite candidly ridiculously well capitalized. According to the Severely Adverse Scenario, the simulated impact on banks would result in them losing about half a trillion dollars and, on average, still having about twice their levels of required Tier 1 Capital.
The stress tests have been held more frequently and with greater care recently. The Fed’s pre-pandemic estimates of bad scenarios imagined much less worse shocks than we faced during COVID-19 (job losses and GDP contraction were worse than in their scenarios), however, the market also bounced back quicker than they imagined. In a reflection of the new post-pandemic reality, the Fed saw much of the projected C&I loan losses as being mitigated by the significantly stronger US consumer.
The primary implication of the stress tests should begin being felt on Monday, at which point banks, who have now gained approval for share buybacks and dividends because of their over-capitalization, will begin issuing new capital plans. The Fed has made a rule that the combination of buybacks and dividends do not exceed the level of profits in recent quarters.
Barclays estimates that the largest banks covered by the recent round of stress tests could return up to $200 billion to shareholders. The Fed’s Vice Chair for Supervision, Randal Quarles, said, “Over the past year, the Federal Reserve has run three stress tests with several different hypothetical recessions and all have confirmed that the banking system is strongly positioned to support the ongoing recovery.”
Asset purchases continued at a pace of $40 billion a month for MBS and $80 billion a month for Treasuries. The benchmark yield on the 10 year is 1.525%.