Why Fed Stress Tests Are Completely Irrelevant

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Includes: BND, TLT, UUP
by: Austrolib

Summary

The Fed just completed stress tests assuming a so-called "severely adverse" scenario.

The severely adverse scenario assumes inflation below 2% and growth bouncing back to over 4% within 2 years. This is not severely adverse.

The Fed does not recognize the possibility of stagflation anywhere in the stress test report. Keynesian theory on which the Fed relies does not account for the possibility of stagflation.

If and when stagflation returns, this will be truly severely adverse. The banking system will be the least of our concerns. The dollar and US Treasuries will be.

The Federal Reserve just completed supposedly rigorous stress tests for all its member banks. These stress tests are said to have simulated a “severely adverse” scenario that tested banks’ capital ratios to make sure they would stay liquid even in times of severe economic stress. All banks are said to have passed. As per the script, we are supposed to applaud and breathe a sigh of relief that the next recession, even if “severely adverse” will not cause a systemic banking crisis. In the immortal words of the Lego movie, “Everything is awesome!”

Except that these stress tests are completely bogus, seemingly designed for the sake of cheerleading the banking system, which can dangerously lead investors into a sense of complacency. Why are they bogus? For two reasons.

  1. Given the colossal amount of excess reserves in the banking system ($2.11 trillion as of May), the notion that any systemically important bank could possibly run out of liquidity at this point is laughable. There are $11.7 trillion in deposits in the US banking system as of now, with required reserves at $178.63 billion. In order to maintain every single dollar in deposit at the current ratio even if all $11.7 trillion were magically wiped out overnight, all that is necessary is to take out $178.63 billion from excess reserves and replenish. There would still be nearly $2 trillion in excess left over even after that. This is obviously a simplification of the process, but conceptually you get the point. There is no liquidity problem or anything close to it. One wonders what exactly is being tested.
  2. The “severely adverse” scenario is not severely adverse at all. It is only severely adverse within the faulty Keynesian framework of what the Fed considers within the realm of possibility. It does not consider the possibility of double digit stagflation as happened in the 1970’s.

Point #1 is self-explanatory. So let’s delve into point #2. According to the full stress test report, the “severely adverse scenario” goes like this (emphasis mine):

In this scenario, the level of U.S. real GDP begins to decline in the first quarter of 2017 and reaches a trough in the second quarter of 2018 that is about 6½ percent below the pre-recession peak. The unemployment rate increases by about 5¼ percentage points, to 10 percent, by the third quarter of 2018. Headline consumer price inflation falls to about 1¼ percent at an annual rate by the second quarter of 2017 and then rises to about 1¾ percent at an annual rate by the middle of 2018.

Here is a table of the severely adverse scenario:

The red box shows the price inflation rate for the severely adverse scenario going out to 2020. CPI-based price inflation never exceeds 2% per annum. We also return to above 4% GDP growth within 2 years of the simulated recession ending (see Q42018, column 2), nevermind the fact that the US has not exceeded 4% annual GDP growth since the Great Recession ended. That was 9 years ago.

This is not severely adverse. It is excessively rosy for a recession scenario.

What would severely adverse truly look like? Something like this. Here are the inflation rates and GDP growth rates from 1970 to today (severely adverse in red circles):

Stagflation happened 4 times since 1970. Once in 1975, once in 1980, for all of 1982, and once in 1991. Yet, according to the Keynesian theory on which Fed monetary policy is based, stagflation is impossible. According to Keynesian theory, inflation cures recession, and recession cures inflation. You cannot have both. But as reality attests to, you can, but the Fed, which causes stagflation by manipulating the money supply, is not equipped to deal with it by its very nature.

When recession hits, the Fed expands the money supply. When expanding the money supply causes too much price inflation, the Fed slows the expansion by destroying currency, which raises interest rates. This is theoretically supposed to balance out the economy. But if recession and price inflation hit at the same time, the Fed cannot balance it out. It must choose, either the dollar, or GDP growth. It cannot have both.

In the early 1980’s, then Fed Chair Paul Volcker chose the dollar over GDP growth by raising the federal funds rate to nearly 20%(!). That is a truly severely adverse scenario. Judging by the graph above, 2008 looks like a tiny blip compared to the period from 1973 to 1982.

And what if this happened today? That would be the true stress test, but the banks would not be the ones really tested because of the excess reserves issue. Once again the Fed would have to choose between the dollar and GDP growth, except this time the solvency of the federal government itself would come into the mix. Back in the 1970’s and early 1980’s, federal debt was still sustainable. 20% interest rates could still be paid. Today they cannot. A 20% overnight fed funds rate at the current $20 trillion debt level would divert all mandatory and discretionary spending into debt service, if it could even by paid at all.

The conclusion? The danger is not in the liquidity or solvency of banks. The banking system is nicely padded. The danger is in the nature and the value behind the padding. If and when a truly severely adverse stagflation scenario shows up, meaning consumer price inflation above 5% and GDP contracting or near it, the banking system will be the least of our concerns. The dollar and the solvency of the federal government will take center stage instead, and it will be time to short the dollar (UUP) and the US Treasury market (BND) (TLT).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.