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April 5, 2018

Jamie Dimon on “When the Next Crisis Begins…”


Interest rates “may go higher and faster than people expect,” the Fed may have to “sell more securities,” and “as all asset prices adjust to a new and maybe not-so-positive environment,” there’s “a risk that volatile and declining markets can lead to market panic.”

JPMorgan Chase CEO James Dimon, in his annual letter to shareholders, discusses a wide-ranging spectrum of issues way beyond the performance of the bank. Practically buried in the very long letter is a warning about the stock and bond markets, the difficulties they may face as inflation may be rising faster than people now expect, and as the Fed may raise rates faster than people now expect, while at the same time unwinding QE, which has never been done before on this scale, and whose consequences remain unknown.

So this is the trimmed down version of that segment of his letter.

Volatility and rapidly moving markets “should surprise no one,” he said. Volatility only shows up as concern when it’s in a downward direction. And it doesn’t take much to trigger it – such as “changing expectations, whether around inflation, growth or recession,” he said. “Extreme volatility can be created by slightly changing factors.”

And he warns that the effects of the Fed’s QE Unwind “will be different from what people expect.”

Since QE has never been done on this scale and we don’t completely know the myriad effects it has had on asset prices, confidence, capital expenditures and other factors, we cannot possibly know all of the effects of its reversal.

We have to deal with the possibility that at one point, the Federal Reserve and other central banks may have to take more drastic action than they currently anticipate.

A simple scenario under which this could happen is if inflation and wages grow more than people expect. I believe that many people underestimate the possibility of higher inflation and wages, which means they might be underestimating the chance that the Federal Reserve may have to raise rates faster than we all think.

While in the past, interest rates have been lower and for longer than people expected, they may go higher and faster than people expect.

And “if this happens,” Dimon said, “it is useful” to look at “all the things that are different or better or worse” than during the last crisis and “try to think through the possible effects.”

Among the things that “are better than during the last crisis in 2009,” he listed: Far more capital and less leverage in the banking system, more collateral in the markets, less total short-term secured financing, safer money market funds, healthier consumers, and vastly improved mortgage underwriting.

While mortgage losses “will go up in a recession, it will be nothing like what happened in the Great Recession,” when mortgage losses rose to over $1 trillion, and the fear of these losses was “a primary reason why there was a devastating loss of confidence in the financial system.” So we might dodge this problem the next time.

But there “some modest negatives,” among them:

About $9 trillion, or 30% of total mutual fund long-term assets are in passive index funds or ETFs, which investors can get out of easily though the underlying assets, such as bonds, may be tough to sell in an illiquid market. And “it is reasonable to worry about what would happen if these funds went into large liquidation.”

“Even more procyclicality has been built into the system. Risk-weighted assets will go up as will collateral requirements – and this is on top of the procyclicality of loan loss reserving.”

Market making is “dramatically smaller” in the bond market than last time. “Virtually every asset manager says today it is much harder to buy and sell securities, particularly the less liquid securities.”

Liquidity requirements, which much higher, are more rigid than before. “Banks will be unable to use that liquidity when they most need to do so – to make loans or intermediate markets…. As clients demand more liquidity from their banks, the banks essentially will be unable to provide it.”

An excessive reliance on models.

“No banks to the rescue this time – banks got punished for helping in the last go-round,” when stronger banks that had absorbed collapsing banks, were hit with big fines for the sins committed previously by collapsed banks. In other words, if a bank collapses, no healthy bank will jump in to absorb it.

And there will be much higher interest rates.

With short-term rates at around 2%, it would be a “reasonable expectation” that the 10-year Treasury “could or should be trading at around 4%.” But the short end “should be” trading around 2.5%. “And this is still a little lower than the Fed is forecasting under these conditions.” Part of the reason why rates are still low is “due to the large purchases” of US debt by the Fed “and others.”

But “this situation is completely reversing,” he said.

The Fed’s QE Unwind is already going on, and “sometime in the next year or so,” many of the major buyers of US Treasuries “will either stop their buying or reverse their purchases,” he said. “Think foreign exchange managers or central banks in Japan or China and Europe.”

While the Fed’s QE-Unwind is still timid, it is picking up pace and is scheduled to reach up to $150 billion a quarter by the end of this year. This will come just when the US government “will need to sell more than $250 billion a quarter to fund its deficit.”

So we could be going into a situation where the Fed will have to raise rates faster and/or sell more securities, which certainly could lead to more uncertainty and market volatility. Whether this would lead to a recession or not, we don’t know — but even that is not the worst case.

If growth in America is accelerating, which it seems to be, and any remaining slack in the labor markets is disappearing — and wages start going up, as do commodity prices — then it is not an unreasonable possibility that inflation could go higher than people might expect.

As a result, the Federal Reserve will also need to raise rates faster and higher than people might expect. In this case, markets will get more volatile as all asset prices adjust to a new and maybe not-so-positive environment.

Remember that former Chairman of the Federal Reserve Paul Volcker increased the discount rate by 100 basis points on a Saturday night back in 1979 in response to a serious double-digit inflation problem. And when markets opened the next business day, the Fed funds rate went up by over 200 basis points.

Also remember that the Federal Reserve is operating with extremely different monetary transmission mechanisms than in the past. The old “money multiplier” has been superseded by the new capital and liquidity requirements. Today’s “excess reserves” (reserves once considered in excess of what banks were required to post in cash at the Federal Reserve – fundamentally reserves that could be lent out) are not lendable, although we still don’t completely understand the effect of this.

“There is a risk that volatile and declining markets can lead to market panic.”

“Financial markets have a life of their own and are sometimes barely connected to the real economy,” he said. So a selloff could leave the real economy unscathed. The relationship is usually the other way around – that markets react to “negative future expectations due to a potential or real recession.” And “in almost all of these cases, stock markets fell, credit losses increased and credit spreads rose, among other disruptions.”

But, “the biggest negative effect of volatile markets is that it can create market panic, which could start to slow the growth of the real economy,” as it did during the Financial Crisis. The probability of that recurring is small, he said. “But because the experience of 2009 is so recent, there is always a chance that people may overreact.”

“One day there will be another crisis, and financial institutions and central banks will need to respond,” he said.

When the next crisis begins, regardless of where or how it starts, multiple actors in the system will take actions — either out of necessity (i.e., they need cash) or sentiment (i.e., they want to reduce risk). This will happen across passive, index and ETF funds, insurance companies, banks and nonbanks.

As individual actors stop providing credit and liquidity in the marketplace, we need to do a better job of understanding how this might unfold. And all this will be happening under a different regulatory regime from before.

So says Jamie Dimon, just when we thought there was nothing ever to worry about again after nine years of central-bank fueled market booms.

Courtesy of Wolf Richter at Wolf Street

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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