Are U.S. Banks Ready for Another Recession?

Just like the NCAA tournament, we’ve got some March Madness going on in the U.S. banking industry, as the U.S. Federal Reserve is about to conduct its next round of bank stress tests!

First up, lemme give you the 411 on the stress tests.

On March 15, the Fed will be releasing the results of its latest bank stress tests of the 19 largest U.S. banks. The study will incorporate a sensitivity analysis of 25 different economic variables, to see their potential effects on the banking industry. Some variables include GDP, interest rates, inflation, mortgage prices, and the number of boyfriends Kim Kardashian will have this year. (Oops, just kidding about that last one.)

Based on the changes in the variables, the study will test the banks on their capitalization ratios, revenues, net profits (or losses) and other factors.

Keep in mind that this is a “what if…” test and not a projection of what will happen over the next few years. The Fed just wants to see whether banks have what it takes to withstand another potential recession. We don’t want another Lehman on our hands now do we?

I suspect that many market players will be keeping an eye out on this report for a couple of reasons.

First, it will indicate whether banks have lived up to their promises to ensure that they are properly funded and that they are following Basel III capitalization requirements.

Second, it could play an instrumental factor in whether or not the Fed will flood the market with another round of quantitative easing measures.

So now you must be thinking, “Alright, but how does this affect the forex market?”

Let’s take a look at the dollar index. A quick scan of its chart will tell you that the dollar has been on quite a tear in recent weeks. It rose aggressively and benefitted from safe haven flows at the start of the month as uncertainty gripped the markets. It then extended its gains even further as non-farm payrolls exceeded expectations last Friday.

USDX 4-hour Chart

If the 19 U.S. banks pass the Fed’s stress tests with flying colors, I can’t help but feel that it’ll work in favor of the dollar, at least initially. After all, it would give the Fed one less thing to worry about and one less reason to pull the trigger on QE3.

Ben Bernanke dealt a pretty heavy blow to expectations of QE3 in his speech earlier this month. I imagine that positive results in the stress tests would be the nail in the coffin for QE3 hopes.

In the medium-term, however, there is a chance that the dollar could give up some of its gains. Risk appetite could pick up on improved investor confidence in the banking sector. In turn, this could lead to a rally in equities and losses for the safe haven dollar.

But then again, those are just my two cents on the matter. How do you think the U.S. banks’ stress tests will play out? Feel free to share your thoughts through the poll and comment box below!