US Treasury yields have fallen below a scenario used by the Federal Reserve to stress test banks, raising concerns about the financial sector’s resilience to the unusual interest rate environment caused by the rush for safe haven debt.
The Fed’s stress test scenario, developed last November, requires Banks to prove they could withstand another economic shock before increasing their dividend pay-outs and share buy-backs.
But regulators are concerned about one area in which the Fed’s assumptions were too rosy. The scenario has the 10-year Treasury bond yielding 2.79 per cent in the current quarter before rising to 3.81 per cent by the end of 2013. Yet 10-year Treasuries rose on Friday, with the yield falling to 2.26 per cent.
The central bank’s decision last week to keep rates ultra-low until at least the end of 2013 is putting further pressure on banks’ ability to generate earnings growth, threatening their ability to build up capital and increase shareholder return.
Last week, Morgan Stanley cut its earnings forecasts for US banks, warning that the squeeze on the margin between their short-term borrowing and longer-term lending would hit profits.
Despite the economic slowdown and market turmoil, most of the parameters in the Fed’s stress scenario have not come to fruition. The scenario shows the US economy sliding back into recession, with the unemployment rate peaking at 11.1 per cent next year and stocks and house prices falling.
Although the unemployment rate is at a disappointing 9.1 per cent, that is still below the 10.6 per cent used for this quarter in the Fed’s scenario. The decline in equities is still far from breaching the central bank’s case – with the Dow Jones Total Stock Market Index at 12259.97 on Friday, compared with 8,809 in the scenario’s third quarter.
Other internal models are coming under pressure in the current environment. American International Group said recently that it would just survive a decline in the S&P 500 index to 923 and a devastating natural disaster. In spite of the wild swings in the stock market, the S&P is still well above 1100.
But Bank of America said its provisions for credit losses were based on a 3 per cent decline in house prices this year and a 1 per cent increase next year. Like the Fed’s stress models, those assumptions are vulnerable to a double-dip recession.
Economic models used to forecast recessions are starting to flash warning signals. A Credit Suisse model says there is now a 30 per cent chance of a US recession in the next six months, up from around 5 per cent just two weeks ago.
Like many such models, it relies on a mixture of financial measures such as stock prices and economic data like jobless claims and housing starts. Slumps in financial markets are often the prelude to recessions.
This kind of forecasting often produces false positives, however. “There have been lots of market downturns that have not resulted in a recession,” said David Munves of Moody’s Analytics.
But he added: “We have been watching credit spreads closely in recent months and they have been hovering between levels consistent with strong company fundamentals and negative macro indicators. What has happened in the last few days is that spreads have tracked back up towards those economic indicators.”
Some European regulators privately complained that the US was being hasty in allowing its banks to increase dividend pay-outs. In the end, most of the 19 groups who were examined were allowed an increase – nominal, in the case of Citigroup for example.
Bank of America, which has been hardest hit by the sudden drop in investor confidence in the sector, had its plan vetoed by the Fed in an embarrassment that still hangs over the company.