Rate-Cutting Fed Warns That Prolonged Rate-Cuts "Increases Vulnerability Of Market To Shocks"

Oh, the irony...

The Fed has just released its twice-yearly Financial Stability Report and it is full of two things - ominous warnings... and swift "but, there's nothing to worry about" retorts.

Our view on the current level of vulnerabilities is as follows:

  • Asset valuations. Asset prices remain high in several markets relative to income streams. However, risk appetite measures that account for the low level of long-term yields on U .S . Treasury securities are more aligned with historical norms for most markets . With the exception of riskier corporate debt, commercial real estate (CRE), and farmland markets, these measures point to a reduction in risk appetite from the elevated levels of 2017 and 2018 .

  • Borrowing by businesses and households. Borrowing by businesses is historically high relative to gross domestic product (GDP), with the most rapid increases in debt concentrated among the riskiest firms amid weak credit standards . By contrast, household borrowing remains at a modest level relative to income, and the amount of debt owed by borrowers with credit scores below prime has remained flat .

  • Leverage in the financial sector. The largest U .S . banks remain strongly capitalized, and the leverage of broker-dealers is at historically low levels . However, several large banks have announced plans to reduce their voluntary capital buffers . Leverage among life insurance companies is moderate, while hedge fund leverage remains elevated relative to the past five years.

  • Funding risk. Estimates of the total amount of financial system liabilities that are most vulnerable to runs, including those issued by nonbanks, remain modest . Short-term wholesale funding continues to be low compared with other liabilities, and the ratio of high-quality liquid assets to total assets remains high at large banks .

Stresses in Europe, such as those related to Brexit; stresses in emerging markets; and an unexpected and marked slowdown in U .S . economic growth are among the near-term risks that have the potential to interact with these vulnerabilities and pose risks to the financial system.

All sounds fine right? But there is this...

"If interest rates were to remain low for a prolonged period, the profitability of banks, insurers, and other financial intermediaries could come under stress and spur reach-for-yield behavior, thereby increasing the vulnerability of the financial sector to subsequent shocks,”

In fact this is exactly what BofA recent warned...

"...some have argued, including former NY Fed President William Dudley, that the last financial crisis was in part fueled by the Fed's reluctance to tighten financial conditions as housing markets showed early signs of froth. It seems the Fed's abundant-reserve regime may carry a new set of risks by supporting increased interconnectedness and overly easy policy (expanding balance sheet during an economic expansion) to maintain funding conditions that may short-circuit the market's ability to accurately price the supply and demand for leverage as asset prices rise."

Fed Governor Lael Brainard reiterated this warning in a statement today that the low-for-long environment “and the associated incentives to reach for yield and take on additional debt could increase financial vulnerabilities.”

The current combination of "very low credit spreads" - measured as the gap between yields on U.S. Treasurys and assets such as corporate debt - "and high levels of indebtedness among risky nonfinancial corporates, including through leveraged loans, merits heightened vigilance."

However, despite this warning, as Bloomberg reports, The Fed seems to take a more relaxed view of the rising stock market than it did in its last report in May.

While equity prices remain high relative to corporate earnings, they are consistent with the low level of interest rates, the Fed said.

“Over the past couple of years, equity prices have been high relative to forecasts of corporate earnings,” according to the report.

However, other measures of investors’ risk appetite in domestic equity markets are in the middle of their historical ranges.”

But then again, The Fed warns about liquidity issues,

For equity futures, “liquidity has become more fragile over time,” the report said.

“It tends to disappear when it is needed the most, when asset price volatility is high.”

The Fed touches on the repocalypse problem, but again the tone is one of "problem solved"...

“Pressures in the repo market spilled over to other markets, including the federal funds market,” the report said.

“The Federal Reserve took a number of steps beginning in mid-September to maintain the federal funds rate within its target range and to ensure an ample supply of reserves. Pressures in short-term funding markets subsequently abated.

But one last warning...

“Should a no-deal Brexit cause distress in systemically important financial institutions in Europe, it would amplify the transmission of economic disturbances to U S and global financial systems,“ the Fed said.

In summary, The Fed is carefully covering their asses by warning that things are getting scary (just in case the world falls apart, "don't say we didn't warn you") and at the same time, that everything is 'contained'.

 

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Full Financial Stability Report