Each year since the financial crisis, the Federal Reserve conducts a series of "stress tests" on the nation's banks to gauge how the country's financial system will respond under various levels of economic distress. While in theory this stress test practice is intended to keep the biggest banks in the U.S. honest about preparing for unexpected problems, it is also an intriguing sneak peak into the kinds of scenarios the Fed is worried about happening.
This is why it's interesting that this year the central bank has included a stress test for how these big banks will handle negative interest rates.
Stress Test Or Global Trend?
It's not entirely shocking that the Fed would be preparing for a scenario where benchmark rates (and, importantly, short-term Treasury yields by extension) remain in negative territory for a prolonged period. For some time, this policy has already been in place in Europe. Last week, Japan's central bank also moved its key interest rate below zero for the first time. In both cases, these measures were taken in order to combat meager economic growth and deflation.
The use of negative rates in the U.S. would be for the same main reasons, but comes with the added problem that the Fed just raised rates. Although the rate hike was small (just 0.25%), it is nonetheless more of a shock to the system to reverse direction and momentum in this way.
Unexpected shifts in monetary policy spell disaster for a living, breathing system that is complex as the U.S. economy. Even though the Federal Reserve maintains a calm optimism to avoid tipping off the markets about how bad the situation could get, the cracks in the armor are difficult to ignore. Manufacturing has fallen for four straight months, while inflation and GDP growth remain on life support. At some point, the Fed will have to acknowledge that the Emperor (the economy) is wearing no clothes at all.
The Sharp End of Monetary Policy
Each stress test is intended to show the Fed which banks are prepared for a possible economic downturn and which banks are vulnerable (and to what extent). At the same time, the vulnerabilities that are being tested for are obviously scenarios that the Fed sees as within the realm of possibility. This is why the negative rate stress test scenario is so telling about whether or not this policy might actually happen.
Yet, a somewhat alarming aspect of the stress tests is the extreme monetary policy tools the central bank intends to use in these kinds of scenarios. Against all logic, most mainstream economic "experts" are convinced that more and more extreme measures will solve the economy's problems.
In fact, some even tout the fact that monetary policy is a tax on the risk-averse as if it's a good thing. Indeed, savers are directly punished by negative interest rates, which charge depositors for holding their money in the bank. Essentially, the overarching logic of "taxing the risk-averse" holds that risk is the driving force behind economic recovery and growth. While this may be true, it discounts the sad reality that such a model requires investors to venture into increasingly risky assets in order to generate the same return they would have with safer assets in the past.
Where does this trail of ever-greater risk-taking end? Moreover, when the Fed is distorting market prices, how does an investor accurately determine risk levels?
The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.