Market Volatility Ahead

Sep 15, 2017 No Comments by

The Federal Reserve is expected to reiterate to the Congressional committee its plan to begin unwinding its multi-trillion bond buying programs as early as this September. Without a doubt this is a big deal. It is so big that it is inconceivable to think that this process will have no effect on financial markets. Our general consensus is that we have arrived at the point for exercising thoughtful concern and caution due to what’s coming our way.

It’s been nine years since the start of this buying spree and market watchers are all speculating about what will happen when the Fed reverses course. Yet there seems to be agreement among most observers that this massive sell-off of bonds by the Fed will certainly impact interest rates, though the impact on stock prices is less clear. Some analysts believe the Fed’s unwinding will have significant effects that will ripple across other sectors of the economy. But quite frankly no one really knows for sure what to expect. There is no pat formula for what is about to happen.

Jamie Dimon, the Chairman and CEO of J.P. Morgan Chase & Co., speaking at a recent conference in Paris, expressed the commonly accepted sentiment. “We’ve never had QE like this before, we’ve never had unwinding like this before. Obviously that should say something to you about the risk that might mean, because we’ve never lived with it before.”


The Fed’s tentative plan is to sell about $6 billion worth of Treasury bonds and $4 billion worth of Mortgage Backed Securities per month and gradually increasing the amount it sells every 90 days. The target is to reach $2 trillion (roughly the amount of currency in circulation), which will take three to five years to complete.

We should also keep in mind that it is not just our own central bank that is doing this. All world central banks have been providing their economies similar massive stimulus since the 2008 financial crisis and now they too are targeting a similar unwinding process as well. The Bank of International Settlements announced this new course just last month ( June 25th.). In other words, the unloading of bonds out of central bank balance sheets will soon be international in scope.

However, there is still more to consider. In addition to these unique central bank maneuvers there is one other important event that is occurring here in the U.S. simultaneously. This is the U.S. Treasury Department’s recent report in response to President Trump’s Executive Order 13772 for regulating the financial system. This is a preliminary report for purposes of creating a new law. Spearheaded by Treasury Secretary Steve Mnucthin, this report among other things is aimed at scaling back excessive government regulations and specifically the Dodd-Frank Act.


Hidden among some of the recommended changes in its 149 pages is a curious suggested change to the current enhanced Supplementary Leverage Ratios (eSLR), or what is often referred to as the necessary stress tests for the financial system’s required Tier 1 Capital needs. This required capital leverage ratio is a part of Dodd-Frank. The report’s suggested changes ironically seem to provide for a loosening of this current law while at the same time providing a way for the banking system to be able to accommodate all these bonds that will soon be pouring into the marketplace.

As it stands today, Treasuries and mortgage-backed securities make up a substantial part of secure investments for financial institutions due to their liquidity. But the significant recommendation of the report is to change how they are taken into account in the determination of the leverage ratio in order to spur the banking system toward more economic growth.

My own interpretation is that although this report may at first seem like an unrelated event to the proposed actions of the Fed, it actually reads as though it is working in tandem with it—almost as though it was planned. The language is technical to be sure, but it is easy enough to understand if you take time to think through the rationale. All these bonds that will soon flood the market will need to be purchased by somebody and it appears that it will ultimately be the banking system.

To see this all in perspective and in order for us to determine our own plans of action in the midst of these converging events we need to walk through some of the specifics.



How We Got Here

Recall that in 2008 as the commercial banking system of the U.S. slid into insolvency due to the unraveling of the mortgage crisis, the Federal Reserve made an extraordinarily large purchase of bank-owned and near valueless mortgage-backed securities in order to stop the spiraling descent and spread of the calamity into the entire financial system. This action was quite literally unprecedented with nothing of equal comparison to it in U.S. banking history.

Just exactly how big a purchase was it? In 2008 alone the Fed’s balance sheet went from $920 billion to $2.3 trillion, with most of its growth occurring between November and December of that year, a period of a mere 60 days! Along with the Congressionally approved $700 billion Troubled Asset Relief Program (TARP), which was literally a taxpayer capital investment in the U.S. financial system (a bailout), the total of the economic stimulus exceeded more than $1 trillion.

Surprisingly, it did not stop there. Fed Chairman Ben Bernanke, determining that dropping interest rates down to zero was not enough, continued to feed the stimulus via open market operations to make sure, as he believed, the Fed’s Great Depression errors were not repeated. By June of 2010 the amount of bond purchases reached a peak of $2.1 trillion.

In November of 2010 a second round of Quantitative Easing (QE) was resumed that added an additional $600 billion of bond assets to the Fed’s balance sheet by June 2011. Round three began in September 2012 and ended in October 2014 adding another $1.64 trillion and accumulating a current total of $4.5 trillion in assets. Today this total includes $2.7 trillion in Treasury bonds and $1.8 billion in mortgage-backed securities. These are all facts that can easily be researched.


Was QE Effective?

Most regular readers of the LMR know by now that this strategy was and is classic Keynesian mechanics. But one surprising critic of Bernanke’s actions comes out of the Research Division of the Federal Reserve of St. Louis. Stephen D. Williamson, vicepresident of the St. Louis Fed and author of a working paper dated July 2015, finds plenty of faults in Bernanke’s decisions during the crisis. In his report he states, “There is no work, to my knowledge, that establishes a link from QE to the ultimate goals of the Fed— inflation and real economic activity.”


The one place where we have all seen QE provide a direct impact is in the S&P 500 where it has soared by 215% since the financial crisis, which also had the curious effect of giving some people a false sense that all is well with the economy. But as far as tangible benefits are concerned only a very limited few individuals, namely those tied to big business, banks, and Wall Street, have actually been economically rewarded. As for the economy at large it has unfortunately remained anemic.

Williamson is quick to point out that as for stimulating inflation, reducing unemployment, or sustaining economic activity, the results of QE are dismal. (A note for clarification: We at the LMR of course do not agree that the Fed should try to boost prices. But the Fed has adopted higher price inflation as an official goal, and Williamson’s point is that the Fed’s chosen means have not been adequate to the stated ends.) Many economic analysts agree with Williamson by simply pointing to the Gross Domestic Product (GDP), which has yet to rise above 2.5 percent for any calendar year since the QE stimulus programs began nine years ago.

In fact a lagging GDP is one prime reason why many, including President Donald Trump, believe we need to try something else in order to stimulate the stagnant economy. The focus has been on matters like overhauling the tax code and stripping away excessive government regulation. This is in essence the slant of the Treasury Department’s report dated June 2017, put out by Steven T. Mnuchin, an ex-Goldman Sachs executive and Wall Street veteran.


Overhauling Dodd-Frank

The Treasury Department’s Report For Regulating the U.S. Financial System made several strong recommendations directed principally at the U.S. Depository System and the Dodd-Frank Act.

In summary, the 149-page report makes many suggestions, but it does take the theoretical posture that the Dodd-Frank Act may have thwarted the potential for QE to achieve a successful full recovery of the economy due to its excessive regulation in certain critical areas of the financial system. Furthermore it claims that Dodd-Frank may still be blocking economic growth unless certain adjustments are made. Pointing specifically to several economic studies, the report stresses that the U.S. is demonstrating the slowest economic recovery of the post-war period. It also exposes the burdens of a prolonged period of low interest rates, which have reduced the return on household savings and returns to institutions—all of which are certainly true.

It further singles out that most banks and Wall Street titans now have sufficient capital reserves, except for the small list of global Systemically Important Financial Institutions (SIFI). Yet there continues to be a lack of credit availability especially in residential mortgage lending, which it says is “the largest stalled asset” followed by small business lending, which has not even recovered to 2008 levels.

Although the report does not recommend eliminating the Volker Rule, a rule that discourages banks from taking too much risk in certain types of investments such as derivatives and private equity financing, it does recommend a substantial amendment to it. This is a suggested change that will clearly benefit big banks since we have known that before the Volker Rule went into effect in 2014,7 the largest U.S. banks generated a sizable amount of profits from currently restricted activities well after the economic downturn of 2008.

With regards to the so-called “bail-in” requirements outlined in the Orderly Liquidation Authority (OLA) under Title II of the Dodd-Frank Act, no comment was offered. But the report did emphasize its full support of the Dodd-Frank’s “core principle of preventing taxpayer-funded bailouts and the safety and the soundness of the financial system.”

But by far the most important suggested change in the U.S. Treasury’s report is in regards to the calculation of the Supplementary Leverage Ratios and the Liquidity Covered Ratio (LCR). The report wants certain key items deducted from the calculation. “In particular, deductions from the leverage exposure denominator should be made for:

  • Cash on deposit with central banks;
  • U.S. Treasury Securities
  • Initial margin for centrally cleared derivatives”

According to the report all three of these assets are considered “low risk” assets, yet by adding them into the leverage ratio calculation it causes the ratio to reflect the bank as being “over leveraged” thereby forcing the bank to either have to sell assets or raise equity in order to continue receiving customer deposits. It is for this reason the report wants them excluded from the calculations altogether. If you take a calculator to these proposed exclusions you can see that it really does position the banks to be able to increase their lending, investing, and purchasing abilities.

Yet clearly this is a loosening of the rules that, depending on how one evaluates it, could potentially re-open the systemic risk problem of “too big to fail” financial institutions once again. At the same time it should also tell us that such a change does pave the way for banks to have more room for the purchases of additional U.S Treasuries and very soon there will be a lot of them to buy.


The Leverage Ratios in Simple to Understand Numbers

Without getting too technical, we need to briefly demonstrate the effects these changes will have on the leverage ratios to understand what the report is talking about. The Dodd-Frank Act, (and the Basel III Accord), established a 3% minimum ratio requirement for the Tier 1 Capital Leverage Ratio. Tier 1 Capital is a bank’s core capital, which is made up of the bank’s common stock and its retained earnings. This number is then divided by all the banks’ other tiered “consolidated assets” in order to arrive at the mandatory ratio.

Using a simple example where $30,000 is the bank’s Tier 1 Capital and the consolidated assets are $1M, we can easily see that the ratio would be 3% and according to the ruling the bank would be adequately capitalized to withstand the shocks of an economic crisis such as what we had in 2008.

However, if the consolidated assets were increased by an additional $500,000 to $1.5 million with the same core capital of $30,000, the ratio would only be 2% and the bank would not have met its stress test ratio requirement. But if we excluded $500,000 from the original $1M in consolidated assets with still the same $30,000 in core capital, the ratio jumps up to 6% and now the bank is well above the required 3% and is sufficiently capitalized.

So, if the $500,000 being excluded happens to be the suggested (a.) cash on deposit with central banks and (b.) U.S. Treasuries, then the bank can now take on more customer deposits and/or buy more U.S. Treasuries to the tune of $500,000. Once again, these are simple numbers and calculations so you need to be extrapolating these numbers in your mind into billions. But this is the main reason for the suggested exclusions.

With regards to suggested asset (c.) initial margin for centrally cleared derivatives, this one exclusion is directly tied to the report’s suggestion of altering the Volker Rule freeing the banks to invest in somewhat risky, but very profitable investments. Even though common sense tells us that accepting initial margin (collateral) for risky transactions actually makes a bank safer, counting these assets into the leverage calculation and with the Volker Rule unchanged as it is, makes banks less profitable. To exclude these assets from the leverage calculation and amending the Volker Rule makes banks, especially big banks, more profitable. The idea is that profitable banks make the economy more robust.



What I have attempted to highlight in this article is what I believe is part of a well-orchestrated plan, designed by top banking officials behind closed doors, to re-shuffle the assets within the banking system once again. The goal of course is to continue to have the banking system profit from this enormous unwinding process in the same way massive profits were achieved in the winding up of it. Though it seems at first that these developments and announcements of the upcoming event are unrelated due to their time sequence and who is actually making them, they are actually all moving in tandem. They are actually showing us where these bonds are going to eventually wind up.

The problem is that in the course of these actions there will undoubtedly be man-made financial tremors and shocks that will ripple throughout the entire economy. Therefore you would be wise to begin your preparations now. Robert Murphy and I have already prescribed a balanced approach that you can follow in the video “How to Weather The Coming Financial Storms.” If you haven’t seen it or need a re-fresher on that strategy click here and get started.


Julie Ann Hepburn, National Private Client Group – Lara-Murphy Report

Knowledge is Power, What's Happening?!

About the author

Julie Ann Hepburn, is a Private Banking Expert and Financial Coach. She is the founder and principal of National Private Client Group, LLC , a Chicago based financial consulting group. Ms. Hepburn is a licensed finance professional, and serves as an agent and consultant for several major mutual insurance carriers. For full bio, please see:
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