Are the Federal Reserve's bank stress tests causing more harm than good?
Many things are spooking investors when it comes to shares of financial firms these days, but one of them is the idea of interest rates turning negative in the United States. The focus on that possibility seems to have been fueled by the "severely adverse scenario" that the Fed asked banks to assess in their 2016 stress tests. The scenario envisions three-month Treasury bill rates going to zero percent in this quarter and -50 basis points, or -0.5 percentage point, in the second half of the year.
After that, the "Wall Street echo chamber" took over, as Michael Cloherty, head of rates strategy at RBC Capital Markets, explained it in a note:
We suspect that there have been many calls from banks to dealer research departments to discuss what LIBOR would look like if Tbill rates fell to -50bp. Typically, when a research person gets a call from four or five clients in a row on the same subject, we assume that this issue is important to everyone, and we write up a report. Clients then see several Street research groups putting out pieces on the same subject, assume that there is fire behind all that smoke, and ask more questions. And the echo chamber begins.
This is not to say that negative yields on three-month Treasuries are some far-fetched notion. They've dipped below 0 percent several times since Lehman Brothers went bankrupt. But the lowest they ever reached was -4 basis points and recently were at about 30 basis points above zero, both a long way away from the -50 basis points envisioned. Still, as this chart starting in September 2008 shows, those yields can fall swiftly:
Maybe it's a good thing that that focus on negative T-bill rates has received all the attention. Imagine if investors became fixated on some of the other nightmares in the "severely adverse scenario."
For example, that part of the stress test also envisions a decline in home prices, a 7.5 percent plunge in real gross domestic product in the second quarter, a 4.5 percent decline in real disposable income in the third quarter, and a rise in unemployment rate to 9.1 percent by the end of the year. In the stock market, the scenario tests a quadrupling of the VIX volatility index and a drop of more than 53 percent in the Dow Jones Total Stock Market Index by the end of the year.
Again, these are simply nightmare scenarios that the Fed requires banks to test themselves against. No one will confuse a Fed stress-test scenario involving a more than 50 percent drop in the stock market with a forecast from the Fed. Yet for some reason -- perhaps because the Fed has so much influence over rates -- the chance of negative interest-rates is one scenario that has captivated imaginations. Also, as Cloherty pointed out, modeling the effect of severely lower rates is difficult, and that could explain all the chatter about it.
So if fingers are to be pointed, at least in this case, point them at the "Wall Street echo chamber" rather than the Fed.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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