“When the Next Crisis Begins…” JPMorgan CEO Jamie Dimon

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by Wolf Richter, Wolf Street:

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.”

Read More @ WolfStreet.com