Fun With The Fed's "Stress" Test

Authored by Nicholas Colas via,

Like many of you, I spent part of the late afternoon reading through the results of the Federal Reserve’s annual stress test of the US banking system. At first blush, everything looks good. Everyone passed. Now investors can look forward to next week’s Comprehensive Capital Analysis and Review, when we hear what sorts of buybacks and dividends these institutions can pay in the year ahead.

It’s difficult not to gasp a little when you look at the “Severely adverse” scenario the Fed used in this year’s review:

  • A 7 quarter recession that leaves GDP 7.5% lower than prior highs

  • Unemployment rises to 10% over the same period

  • Inflation drops to 1% and short term Treasuries yield close to zero

  • At the same time, investors shun long term Treasuries and yields there remain unchanged

  • Investment grade and mortgage yield spreads blow out to 5.75% and 3.5% respectively

  • US stocks drop by 65% in early 2019, and the VIX goes over 60

  • House prices drop 30% and commercial real estate by 40%

I don’t know about you, but to me that looks like the recipe for revolution more than a regulatory what-if scenario, but let’s go with it.

Two points:

#1) If the US banking system is really as robust as the Fed’s analysis indicates, doesn’t that merit a higher multiple on domestic stocks than historical norms? A bullet proof banking system should be worth a systematic premium over a shaky one, after all. America’s banks should be able to provide capital in even a severe downturn, make orderly markets if they have capital markets desks, and generally act as they would at any other point in the economic cycle. That would be a welcome change.

Now, there is a headwind to this positive case: the Financial sector is 14% of the S&P 500, and the regulatory process that makes them systematically safe also reduces their structural return on capital. So we’re unlikely to see much P/E expansion in the group, but every other sector - consumer or industrial - should get an uptick. A robust financial system should make the next recession easier than most previous ones by limiting any shock to the supply of credit, after all. Trough earnings will be higher than expected, and valuations should expand.

This is ultimately a cyclical argument, which means we’ll have to see it work in the next downturn before investors are willing to pay higher multiples. But for those investors who actively consider 5-10 year equity investment horizons, this is a bullish case we’ve not read anywhere else.

#2) If the Fed’s stress tests have a fatal flaw, it is that they assume a “V” bottom from the near-death levels they outline in their requirements. This doesn’t get much attention in the Fed’s document (link at the end of this note) but as near as we can tell, this is what they assume in the “Severely adverse” scenario for a recovery:

  • Unemployment improves in the 6 quarters after the peak by almost 2 points

  • GDP growth turns positive 4 quarters after its trough

  • US equity markets recover almost all their losses in the 2 years after the bottom

  • Corporate bond spreads recover to near 2014 levels 7 quarters after they peak

  • The VIX breaks below its long run average (20) just 2-3 quarters after the Dow trades at 10,000

Some of those – GDP and unemployment – we can see; the Dow’s recovery, bond spreads tightening and the VIX seem fanciful at best. We understand the Fed’s intent is to model another 2007-2008 scenario, but perhaps the next downturn will be different. For example:

  • The next recession, even a garden-variety contraction, will come just as artificial intelligence, robotics, drones, and other technologies hit their strides. All those advances have been invisible in the unemployment data because the US economy is growing.

    Take it from an old cyclicals analyst: companies do their big restructurings in economic downturns, not expansions. The next period of contraction is when capital will substitute for labor at an accelerating rate.
  • At the start of 2007, US public debt-to-GDP was 63%; it is now 106% (yes, we include Social Security). There will potentially be less room for fiscal stimulus in the next downturn, especially since every other developed economy has the same problem (which may be why the Fed’s assumptions include no change to long term yields).

The upshot here is that the next recession – especially a severe one – may not be anywhere near as easy on the way out as the Fed’s scenarios portray. 

So yes, the system is safe at the bottom of a 2007-style crack. But what if the recovery is much slower?

Since the Fed assumes a “V”, what happens if it is an “L”. We don’t know; they don’t include that possibility.

And what does it mean that the most systemically important banks in the world are in a bear market?


PrayingMantis Wild Bill Steamcock Fri, 06/22/2018 - 13:18 Permalink


   ... in order to understand the Rothschild-owned private bank “US Federal Reserve”, one must read what transpired over a century ago detailed in this free online copy of the book, “Secrets of the Federal Reserve” (scroll down to the book proper) ... here you’ll find the (((planners))) of this US .gov covert takeover ... the who, what, when, where, why and how this covert operation was meticulously orchestrated as part of the talmudic philosophy of “divide and conquer” ... “let the goyims fight it out among themselves while (((we))) loot and plunder their treasuries” ... 

   ... >>> ... ...

    ... on pages 46 - 47, it says ...

        ... “ ... What John Moody did not know, or did not tell his readers, was that the most powerful men in the United States were themselves answerable to another power, a foreign power, and a power which had been steadfastly seeking to extend its control over the young republic of the United States since its very inception. This power was the financial power of England, centered in the London Branch of the House of Rothschild. The fact was that in 1910, the United States was for all practical purposes being ruled from England, and so it is today.

         ...  “ ... The ten largest bank holding companies in the United States are firmly in the hands of certain banking houses, all of which have branches in London. They are J.P. Morgan Company, Brown Brothers Harriman, Warburg, Kuhn Loeb and J. Henry Schroder. All of them maintain close relationships with the House of Rothschild, principally through the Rothschild control of international money markets through its manipulation of the price of gold. Each day, the world price of gold is set in the London office of N.M. Rothschild and Company.

Although these firms are ostensibly American firms, which merely maintain branches in London, the fact is that these banking houses actually take their direction from London. Their history is a fascinating one, and unknown to the American public, originating as it did in the international traffic in gold, slaves, diamonds, and other contraband. There are no moral considerations in any business decision made by these firms. They are interested solely in money and power.


                                 ... it’s better to light a candle than curse the darkness ...



      ... author Mullins’ notes about his book, Secrets of the Federal Reserve  ...

      ... “ ... I did research four hours each day at the Library of Congress, and went to St. Elizabeth’s Hospital in the afternoon. Pound and I went over the previous day’s notes. I then had dinner with George Stimpson at Scholl’s Cafeteria while he went over my material, and I then went back to my room to type up the corrected notes. Both Stimpson and Pound made many suggestions in guiding me in a field in which I had no previous experience. When Pound’s resources ran low, I applied to the Guggenheim Foundation, Huntington Hartford Foundation, and other foundations to complete my research on the Federal Reserve. Even though my foundation applications were sponsored by the three leading poets of America, Ezra Pound, E.E. Cummings, and Elizabeth Bishop, all of the foundations refused to sponsor this research. I then wrote up my findings to date, and in 1950 began efforts to market this manuscript in New York. Eighteen publishers turned it down without comment, but the nineteenth, Devin Garrity, president of Devin Adair Publishing Company, gave me some friendly advice in his office. "I like your book, but we can’t print it," he told me. "Neither can anybody else in New York. Why don’t you bring in a prospectus for your novel, and I think we can give you an advance. You may as well forget about getting the Federal Reserve book published. I doubt if it could ever be printed."

This was devastating news, coming after two years of intensive work. I reported back to Pound, and we tried to find a publisher in other parts of the country. After two years of fruitless submissions, the book was published in a small edition in 1952 by two of Pound’s disciples, John Kasper and David Horton, using their private funds, under the title Mullins on the Federal Reserve. In 1954, a second edition, with unauthorized alterations, was published in New Jersey, as The Federal Reserve Conspiracy. In 1955, Guido Roeder brought out a German edition in Oberammergau, Germany. The book was seized and the entire edition of 10,000 copies burned by government agents led by Dr. Otto John.

The burning of the book was upheld April 21, 1961 by judge Israel Katz of the Bavarian Supreme Court. The U.S. Government refused to intervene, because U.S. High Commissioner to Germany, James B. Conant (president of Harvard University 1933 to 1953), had approved the initial book burning order. This is the only book which has been burned in Germany since World War II. In 1968 a pirated edition of this book appeared in California. Both the FBI and the U.S. Postal inspectors refused to act, despite numerous complaints from me during the next decade. In 1980 a new German edition appeared. Because the U.S. Government apparently no longer dictated the internal affairs of Germany, the identical book which had been burned in 1955 now circulates in Germany without interference.



                             ... the best part of waking up is opening your eyes ... 


In reply to by Wild Bill Steamcock

PrayingMantis shovelhead Fri, 06/22/2018 - 14:43 Permalink


   ... “ ... Light a candle, curse the glare. ... “ ... 

            ... just simply close your eyes and don’t let (((them))) bother you ... it’s also known as ... “turning a blind eye” ... to avoid the “glaring” truth ...


     ... “ ... The best part of waking up is discovering you're not dead. ... “ ... 

           ... well, fortunately, we all suffer the same fate of death, sooner or later, whether we like it or not ... 



   ... I’ll leave you with a Pittacus Lore tidbit ... “ ... “Take a chance and risk it all or play it safe and suffer defeat.” ... “ ... 


   ... and a Rothschild tidbit ... “ ... Give me control of a nation’s money and  I care not who makes its laws ... “ ... 


            ... you can take your pick, @ shovelhead, and suffer whatever consequences each would produce ...


In reply to by shovelhead

TheBigCluB Fri, 06/22/2018 - 12:54 Permalink

when enough people catch on to the fact that the bankers create money from nothing interest free and then loan it to the suckers at 18% cc interest enslaving them while at the same time paying exactly .05% out to savings destroying their pension funds...

sooner or later someone is going to get hurt

rejected Fri, 06/22/2018 - 13:01 Permalink

We no longer have a banking system.

We have a legalized Mafia loan sharking, money laundering operation.

They counterfeit money for loans out of thin air then want you to repay in earned money from low wage jobs.

Their money is constantly devaluing and inflating prices due to gov deficit spending.

Their intention is to own it all while putting the lemmings in debt servitude.

I think they have succeeded.

Quivering Lip Fri, 06/22/2018 - 13:02 Permalink

I hope ZH gets paid by Nicholas to spew government propaganda.

The next recession, even a garden-variety contraction, will come just as artificial intelligence, robotics, drones, and other technologies hit their strides. All those advances have been invisible in the unemployment data because the US economy is growing.

No Nicholas the unemployment numbers are pure bullshit because we don't count 100 million people in said numbers. The economy isn't growing if you take out deficit spending. It's been contracting for 18 years. Throw in real inflation and it's been a down right depression.

The only thing you got right was AI and robotics taking what little jobs will be left. I'm sure at that time they'll be 125 million people not counted in the real unemployment numbers.

TheBigCluB Fri, 06/22/2018 - 13:05 Permalink

a fuckin box of frosted flakes is 5 bux and there is no flakes in it.

but no 2..

i must find a decent cave with running water or die in the wal mart shooting it out over a can of beannie weannies

Trader Maximus Fri, 06/22/2018 - 13:56 Permalink

So far the rotation that Shepwave Traders have been talking about this week is happening.  Dow needs to rally a little higher I think.  Russ index is not giving sell signal    


looks like shepwave is about the only analysts who know how to trade these markets from week to week.

Let it Go Fri, 06/22/2018 - 14:03 Permalink

While economic growth appears robust and a solid GDP number can result in a feel-good moment that builds consumer confidence it can also mask growing weakness in various parts of the economy. Quantity simply does not make up for poor quality, we are talking about two totally different animals.

The false narrative that simply growing the size of an economy even by using deficit spending undercuts the importance of a solid economic and the long-term stability of the financial system. The article below delves into poor investments.

 http://Economic Growth Does Not Equal Economic Strength.html