Wednesday April 5

Stocks fell today after the release of the FOMC minutes reversed early session gains. The S&P 500 fell 0.3% to 2,352 and the Dow Jones fell 0.2% to 20,648. The KBW Bank index lost 1% while utilities gained 0.6%. Economic data today showed that the ADP Employment report came in at 263,000 compared to the consensus of 170,000 which is a significant beat. That bodes well for the Friday NFP number. The February number was revised downward however. The PMI services index slid slightly from last month to 52.8. The ISM non-manufacturing index was slightly below consensus at 55.2. The US two year Treasury yield fell 2bp to 1.23%. The ten year Treasury yield fell 3bp to 2.33%. Accordingly 2yr vs 10yr bull flattened to 1.10%. The dollar was weaker on the day against peers. USD was little changed against EUR to $1.0677. USD fell 0.1% against JPY to Y110.61. USD fell 0.4% against GBP to $1.2493. The EIA petroleum status report showed that crude oil inventories increase by 1.6m barrels last week which is a 7.4% increase from this time last year, which was generally interpreted as bearish. WTI fell 0.4% to $50.85. Brent fell 0.2% to $54.08.

There is an active debate between the industry and regulators regarding the marginal benefits and costs of bank capital. On one side of the argument are professionals like Jamie Dimon, who has consistently complained that high levels of bank capital are hurting banks and their ability to function in the economy. On the other side of the argument are regulators who still want further increases in bank capital levels. A report by Simon Firestone, Amy Lorenc, and Ben Ranish who are all researchers from the Federal Reserve Board argues in favor of higher bank capital. The argument goes that over a long period of time the economic costs from lower incomes, reduced investment, higher unemployment, psychological effects, and social damage associated with financial crises sets economies back significantly and knocks them off track from their potential. With those economic costs in mind the regulators think that is best to do everything possible to reduce the probability of financial crises and reduce the severity of financial crises. In both cases increasing bank capital is the best way to do so. With that line of thinking they think the optimal capital ratio for banks is more than double the current level, which is a very very significant change. Currently banks have to hold 12.5% of risk-weighed assets, and an increase to 25% they argue would cut the probability of financial crisis in half. The research from the Fed researchers argues that by doubling capital ratios that over a long period of time it could increase GDP growth by 1% annually since the present value of the cost of future crises would be eliminated. Banks argue that higher capital ratios would increase the cost of loans for customers. The Fed researchers counter that point by saying that for each 1% increase in bank capital it would increase borrowing costs by 7bp. Therefore the suggested 13% increase in bank capital would result in an increase of 91bp for companies and household borrowing costs. Regardless the political sphere is shifting towards less regulation as opposed to more so these changes would face an uphill battle given the current regulatory momentum.

Some industry professionals also want to review regulations that were established in April 2012. The Jumpstart Our Business Startups Act, or Jobs Act was intended to make it easier and more convenient for companies to raise money in public markets. While some aspects of the regulation have been successful, professionals argue that other aspects of the Jobs Act encourage companies to stay private for longer which has caused a decrease in IPOs. The Jobs Act requires companies with a large number of shareholders to publish financial statements and accounts, and it also provides ways for companies to confidentially file for IPO. The first aspect is what some investors argue is encouraging companies to stay private for longer. Another possible explanation could be increased M&A activity as a way to liquidate stakes as opposed to IPO. In the early 1990s just 20% of venture backed companies liquidated through M&A. Between 2001 and 2016 that figure was as high as 90%. One way to approach this reason as a deterrent of IPO activity would be to increase antitrust regulation. The second part of the regulation has been useful as nearly 75% of IPOs since the Jobs Act have used that method. Nevertheless the number of US listed companies as well as the number of IPOs has been on a downward trend since the early 2000s. As private markets get more and more sophisticated with venture capital becoming increasingly possible, household investors lose access to investment opportunities. A healthy IPO market is important for two reasons. One data has shown that companies that IPO increase their employment by a total of 2.2 million jobs for a total of 2,766 companies between 1996 and 2010. The second is that household investors look to new issuances as a way to build wealth, and if those opportunities are being kept from them then that could increase inequality.

The FOMC minutes showed that the Fed generally agreed on starting to unwind the balance sheet towards the end of this year. The Fed currently holds $4.5tn in Treasuries and agency MBS compared to less than $1tn before the 2008 financial crisis. At the March 15th meeting the minutes showed that “most participants anticipated that gradual increases in the federal-funds rate would continue and judged that a change in the Fed’s reinvestment policy would likely be appropriate later this year.” They did not provide clarity as to the pace of the cessation of reinvestments or the terminal size of the balance sheet. Strategists at JPM suggest that the target level could be between $3.2tn and $3.5tn. Economists at GS think the target is between $2tn and $2.9tn. Both of those are far larger than the pre-crisis number, but the Fed hasn’t provided any color on that topic. Bill Dudley has made comments suggesting that after starting the balance sheet reduction process they may slow the pace of rate increases. The market for Fed funds futures is currently pricing in a 63% chance of higher rates in June according to CME. It is expected that the Fed will halt its reinvestment policy as a way of reducing the size of its balance sheet as opposed to outright asset sales. Regardless it puts upward pressure on rates. Ben Bernanke has recently argued in favor of keeping a large balance sheet.

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Wednesday April 5

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