Dear Janet Yellen: Here Is Your Own Watchdog Warning About Financial Stability Risks In "Red And Orange"

In the most interesting exchange during Janet Yellen's final news conference, CNBC's seemingly flustered Steve Liesman asked Janet Yelen a question which in other times would have led to his loss of FOMC access privileges: "Every day it seems the stock market goes up triple digits on the Dow Jones: is it now, or will it soon become a worry for the central bank that valuations are this high?"

Yellen's response was predictable, colorfully so in fact.

Of course, the stock market has gone up a great deal this year. And we have in recent months characterized the general level of asset valuations as elevated. What that reflects is simply the assessment that looking at price-earnings ratios and comparable metrics for other assets other than equities, we see ratios that are in the high end of historical ranges. And so that's worth pointing out.  But economists are not great at knowing what appropriate valuations are, we don't have the terrific record. And the fact that those valuations are high doesn't mean that they're necessarily overvalued.


So I think what we need to and are trying to think through is if there were an adjustment in asset valuations, the stock market, what impact would that have on the economy? And would it provoke financial stability concerns? 

Here is the best part from Yellen's response:

... I think when we look at other indicators of financial stability risks, there's nothing flashing red there or possibly even orange. We have a much more resilient, stronger banking system.

Actually, Janet, no you don't, because just one week ago, in the annual report from the Office of Financial Stability - one which as Fed Chair one would certainly hope you had read, and which we discussed at the time - issued a very clear and very explicit warning about the vulnerabilities in the financial system, and which warned that the "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 noted 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." 

The OFR further cautioned that valuations 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."

Oh, and just to make it very clear how high the finability stability risk is, the OFR was kind enough to color-code the threat. It was, drumroll, in red and orange.

So which is it Janet: "nothing flashing red there or possibly even orange"... or as the OFR explicitly notes, everything flashing red and orange, with the added warning that the "increase in already-elevated asset prices and the decrease in risk premiums may leave some markets vulnerable to a large correction."


spastic_colon Thu, 12/14/2017 - 12:18 Permalink

this is the kind of stuff i started reading ZH for........not the tabloid clickbait shit we are seeing too much of anymore.from the actual report pg 34; (bold from me)"...The other view holds that low volatility may serve as a cat-alyst for market participants to take more risk. By this logic, low volatility makes the financial system more fragile."

Oracle of Kypseli RedPillGirl Thu, 12/14/2017 - 16:27 Permalink

A financial guy is walking on a beach in California and finds a bottle, he gets the cork out and a one-wish genie comes out and asks for a wish. So the guy proceeds to tell her how he loves the beach and he will like to have a bridge accros the ocean to Honolulu. The genie laughed and said that's impossible so I will just give you one more chance. So then the guy thinks for a bit and he says: "I want to understand FED speach." Then the genie says: "How many lanes to you want on that bridge?" 

In reply to by RedPillGirl

MortimerDuke vofreason Thu, 12/14/2017 - 17:32 Permalink

I agree with your basic premise - the site used to be frequented by market people who shed light on some of the darker shadows of the system.  It was very informative and I learned quite a bit from what had to have been some pretty influential folks working for some influential firms.  Hell, the idea for my dissertation came from the Hedge.  But I think you and I see the devolution differently.  In the midst of the crisis, you would have never heard anyone cheer on the socialization of risk.  Now this is a favored stomping ground of socialists of all stripes, national or otherwise.

In reply to by vofreason

mily Thu, 12/14/2017 - 12:15 Permalink

Come on, we all know they know. I remember in one of the interviews Kyle Bass mentioned he had spoken with one of the top 5 CB heads and he admitted they knew. Everything else is appearances and lies to promote "stability". Just dig out what Ben Shalom was saying prior to 2008 melt down

khakuda Thu, 12/14/2017 - 13:01 Permalink

This is great. It is hard to listen to the bullshit coming out of her mouth. Complete lies.

The Fed should be worried when the market decouples from underlying fundamentals. It has ultimately caused instability and deflation every time this happens. PEs are the only measure not off the charts because monetary policies lowered interest costs and fiscal policy reduced corporate taxes. All at the expense of savers and current and future taxpayers. Price versus sales, ebitda are crazy high expensive and interest rates are well below free market by government edict.

I cringe when she says rates are almost normalized. Uh, if I get 3% at the bank, I take home 2% after tax which means my purchasing power stays even in 2% inflation they seek. So, a 1.25% short rate is less than half of normal if a zero Real rate is normal, WHICH IT IS NOT, it is still too low.

Seriously, short rates shouldn't be below 2% barring a war or depression.

She is either dumb or lying.

Ron_Mexico khakuda Thu, 12/14/2017 - 13:22 Permalink

I've said this a thousand times: banks are helped by deflation, because they get paid back in currency that is worth more than what they lent out. People who owe money, otoh, are pretty much screwed. The panic of '08 showed how quickly the deflationary tonic passes through the system. Now I know you "think" the federal government, as the largest debtor of them all, would be really screwed by deflation.  The thing is that they can print money and they don't borrow per se, but issue bonded debt, which puts them in a much better position than Nikky Sixpack to survive until reflation occurs.  And don't think that the Fed and the federal govt haven't figured this out. 

In reply to by khakuda