Banks stress test, stock market, and gold

You probably already heard of the Dodd-Frank Act Stress Test that puts 31 big banks through a crisis scenario. They basically test a wide array of scenarios that goes from a small drop in the stock market to a severe collapse of real estate, the stock market, and main street economy.

Such a scenario would include an unemployment rate of 10%; a 25% decline in home prices; a stock market drop of nearly 60% and "a notable rise in market volatility."   USA today

This test is the first half of the big test (the second one is a qualitative test), and the Federal Reserve concluded that it was a success for all 31 banks. 

All 31 U.S. banks passed a 5 percent minimum hurdle for top-tier capital in an annual health check by the Federal Reserve, the central bank said on Thursday, as the industry continues to rebuild buffers after the crisis. Yahoo Finance

You can access the complete test by clicking here.

Should we be surprised of that good result? I don’t think so. If we look at the chart below, we can see that Reserve Balances with Federal Reserve from banks are at an all time high.

In simple terms, after the crisis the Federal Reserve “printed” the money and sent it to reserve accounts. Banks can then expand the currency supply and create more chequebook money through Fractional Reserve Lending.

This newly created money is supposed to flow into main street economy, but the reality is that it has found its way in majority into some assets such as the stock market. Matter of fact, you can take a look at the velocity of M2 Money Stock on the chart below.

This shows that while banks get healthier and the stock market rises, money is not circulating in the real economy. So I’m not really surprised that banks passed the test with a good score. They have plenty of reserves to support a recession.

The stress tests are so named because they measure whether the banks have enough capital to withstand major economic stressors, such as the 2008 collapse of the housing market. A passing grade means they have enough capital to withstand, say, rising levels of unemployment or plunging commodity prices. - USA Today

Now, the real question that we can ask ourselves is if regular people would pass a stress test. Let’s take a look to Real Median Income to answer the question.

Since the crisis regular people earn less money. But at the same time it looks like they understand the importance of saving money since the crisis as you can see on the chart below.

However, I don’t think the majority of people would pass a stress test. If there was a major crisis, the system and banks would be ok for a certain period of time, but I think regular people would suffer.

Another interesting point is the correlation between Reserves Balances and the S&P500 as you can see on the first chart of this article. It basically shows that if the S&P500 would crash by 60%, banks have a big enough cushion. It also shows that when they’ll start pulling out the money from the stock market there will be a danger for inflation if they inject it in the real economy.

At that step, we may see a rush into gold to protect wealth. But before that turning point, I doubt gold will be traded at August 2012 levels. However, I believe gold will remain of strong value in the meantime.

In conclusion, I don’t think a crisis would crash the whole system and banks like some people say. However, I think it will be a much greater threat to regular people who could see their wealth be wiped out if they don’t protect it.