One wonders if the Fed ever reads the reports issued by the Office of Financial Stability, which does a surprisingly good job of laying out the risks facing the market at any one time, which incidentally are far greater than various Fed presidents would care to admit. If it did, it would learn from the just published annual report, that "market risks — risks to financial stability from movements in asset prices — remain high and continue to rise" and that "low volatility and persistently low interest rates" both of which have been caused by the Fed and other central banks "may promote excessive risk-taking and create vulnerabilities."
While the OFR said that strong earnings growth, steady economic growth, and increased expectations for stimulative fiscal policy have provided further support to asset valuations, this "increase in
already-elevated asset prices and the decrease in risk premiums may leave some markets vulnerable to a large correction," a polite government term synonymous with "crash." It then notes that "such corrections can trigger financial instability when important holders or intermediaries of the assets employ high degrees of leverage or rely on short-term loans to finance long-term assets." Furthermore, echoing Minsky, the OFR did its best paraphrase of "stability is destabilizing" by noting that "historically low volatility levels reflect calm markets, but could also suggest that the financial system is more fragile and prone to crisis."
Speaking of valuations, the OFR was clear to warn that these are "high by historical standards. The cyclically adjusted price-to-earnings ratio of the S&P 500 is at its 97th percentile relative to the last 130 years. Other equity valuation metrics that the OFR monitors are also elevated."
Next, the OFR repeats what we observed in October in "US Homes Have Never Been More Unaffordable", and cautions that "real estate is another area of concern. U.S. house prices are elevated relative to median household incomes and estimated national rents."
The watchdog next looks at the bond market where it, too, finds that "valuations are also elevated" in bond markets. Of particular interest is the OFR's discussion on duration. Picking up where we left off in June 2016, and calculates that "at current duration levels, a 1 percentage point increase in interest rates would lead to a decline of almost $1.2 trillion in the securities underlying the index."
It admits, however, that this is a low-ball estimate which "understates the potential losses" as it "does not include high-yield bonds, fixed-rate mortgages, and fixed-income derivatives", which would suggest that the real number is likely more than double the estimated when taking into account all duration products. As a reminder, Goldman calculated the entire duration universe at $40 trillion as of the summer of 2016; by now the number is substantially greater.
The OFR does, however, warn that "a sudden decline in bond prices would lead to significant distress for some investors, particularly those that are highly leveraged. For example, in the “bond massacre” after interest rates suddenly spiked in 1994, Orange County, California, filed for bankruptcy due in part to losses on its mortgage derivatives portfolio. The potential market losses from an interest rate spike are now much higher than they were in 1994, adjusted for inflation (see Figure 19)." It also correctly notes that, "market participants also may overreact to an interest rate spike, as arguably happened during the 2013 bond market sell-off known as the taper tantrum."
And speaking of investor leverage, something which the Fed has blissfully ignored, assuming - incorrectly that it is far lower than during the financial crisis, the OFR side bars into an inteesting discussion of why volatility is as low as it is, and what could happen if it spikes:
There are two prominent views about what drives low-volatility environments. One view holds that low volatility simply reflects the view of market participants that the probability of a recession is low. Consensus analyst estimates call for a robust 11 percent increase in corporate earnings this year. In addition, the variation in estimates across forecasters is low for corporate earnings, economic growth, and inflation. Low variation may imply low uncertainty about the underlying fundamentals.
The other view holds that low volatility may serve as a catalyst for market participants to take more risk. By this logic, low volatility makes the financial system more fragile. This phenomenon is known as the volatility paradox. There are a number of channels through which low volatility may contribute to greater leverage and risk-taking (see OFR, 2017c). Low volatility may lull investors into underestimating the odds of a volatility spike. Investors may also reduce their hedging activity, understating the risk in their positions.
Incidentally, the "other view" is precisely what Citigroup belives is the accurate one, as we demonstrated earlier today with the following chart (and discussion) of what the the self-reinforcing, low-vol market equilibrium created by central bank backstops looks like.
While the OFR is not yet ready to admit that this toxic feedback loop is the correct representation of the market, and instead writes that "distinguishing which view is true for the current low-volatility environment is difficult" it concedes that there is some evidence that investors have increased leverage in recent years, something the Fed has been especially loathe to do.
To underscore this, the OFR first shows that "the margin debt balances relative to market capitalization on the New York Stock Exchange are displayed in Figure 15. The ratio increased from 2002 to 2007 amid low volatility, declined after the crisis, and has been climbing since the crisis as volatility again reached long-term lows."
Here the OFR also correctly writes that "this ratio is not a complete measure of investor leverage, as it doesn’t include other means through which investors can take on leverage, such as derivatives positions."
Meanwhile, the real leverage continues to pile up among the hedge fund community which as Goldman recently found, has hit record levels. Here the OFR points to "large investors who continue to be highly leveraged and, for that reason, may be susceptible to a sudden increase in volatility." Putting the number in context, it then highlights that "the top decile of macro and relative-value hedge funds has been leveraged about 15 times in recent quarters. Combined, these funds account for more than $800 billion in gross assets, about one-sixth of all hedge fund assets."
Well, as the Fed would say, "it's only 15x leverage": LTCM has an effective leverage ratio of more than 250-to-1 when it blew up, unleashing the era of the Fed market put.
Which is probably why the OFR ends on a positive note: in its conclusion, the watchdog said that when it weighed the financial system’s resilience against its vulnerabilities, "overall risks to stability remain in the medium range."
Which means that no action will be taken, and that investor leverage will continue to rise, and volatility keep falling, until the next "large correction" forces a sharp, quick reset.
Source: 2017 Financial Stability Report