The Fed: Dovish on Rates, Hawkish on Banks

Investors are satisfied with the Fed's dovish stance, but investment banks had better watch out.

Apr 9, 2014 at 7:00PM

And back up we go! After U.S. stocks posted three consecutive losing days (ending Monday), this elicited some handwringing from analysts and financial journalists; however, with two days of gains now under our belt, the benchmark S&P 500 is back within 1% of its all-time high -- which it achieved only a week ago. Today, stocks got a little help from the 2 p.m. ET release of the Federal Reserve's minutes of last month's monetary policy meeting (see the following graph), with the S&P 500 and the narrower Dow Jones Industrial Average (DJINDICES:^DJI) both gaining 1.1%. The Nasdaq Composite Index, which has been struggling a bit lately, rose 1.7%, which puts it back into positive territory for the year.

^GSPC Chart

^GSPC data by YCharts

Speaking of handwringing, the Fed minutes showed some policymakers were concerned in March that investors would misinterpret their new interest rate projections (they did), which were released at the conclusion of the Federal Open Market Committee's policy meeting of March 18-19. In the Fed's language:

A number of participants noted the overall upward shift since December in participants' projections of the federal funds rate included in the March (projections), with some expressing concern that this component of the (projections) could be misconstrued as indicating a move by the Committee to a less accommodative reaction function.

In plain English, some participants were concerned that the market would mistakenly equate a rise in the Fed's interest rate projections with a shift to a more hawkish monetary policy. The final policy statement emphasized that this was not the case, and Fed Chief Janet Yellen tried to minimize the importance of the "dot plot" illustrating the interest rate forecasts during the press conference. Alas, those efforts were for naught, particularly once Yellen made an off-the-cuff remark that suggested that the Fed could raise its main policy rate as early as April 2015.

The Fed and Yellen have since managed to reassure investors with regard to their dovish stance, but this was yet another example of the awkward mating dance between the Fed and financial markets. Investors ought to expect more instances of Fed-related volatility over the next couple of years, as policymakers unwind a monetary stimulus program that is unprecedented in its size and scope.

Seperately, the Fed, the FDIC, and the Comptroller of the Currency finalized bank leverage rules on Tuesday for the largest institutions, requiring them to have at least a 5% leverage ratio (a higher ratio of equity to total assets indicates lower leverage) at the holding company level and 6% at the bank subsidiary level. This will force the eight banks affected -- Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs (NYSE:GS), JPMorgan Chase, Morgan Stanley (NYSE:MS), State Street, and Wells Fargo -- to hold $68 billion in additional capital.

The focus on the leverage ratio -- which does not use risk weights for different asset classes -- is meant to preclude the possibility of banks gaming the system through the use of internal risk models. Furthermore, Dan Tarullo, the Fed governor who is responsible for regulation warned that the Fed could impose an additional risk-based capital surcharge that would penalize banks that use significant amounts of short-term financing. By virtue of their business model, standalone investment banks Morgan Stanley and Goldman Sachs are thus squarely in his crosshairs. This will surely have lit a fire under these banks (and their lobbyists), as any capital surcharge is a potential drag on profitability.

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Alex Dumortier, CFA,  has no position in any stocks mentioned. The Motley Fool recommends Bank of America, Goldman Sachs, and Wells Fargo and owns shares of Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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