For a Yellen testimony which explicitly focused on “financial conditions” which have become “less supportive of growth” as one of the chief risks facing the Fed’s rate hike philosophy, we were surprised to find that the list of troubling developments “related to financial stability” as laid out in the Fed’s Monetary Policy Report to Congress which accompanies the chairwoman’s testimony, was relatively sparse.
In fact, according to the main highlights, not only are financial conditions not deteriorating, but they are improving, according to the MPR. Here are the highlights:
- Financial vulnerabilities in the U.S. financial system overall have continued to be moderate since mid-2015
- Vulnerabilities owing to leverage and maturity transformation in the financial sector remain low
- Net secured borrowing by dealers, primarily used to finance their own portfolios of securities, continued to decrease and is near historical lows
- Overall asset valuation pressures have eased
- Commercial real estate prices continued to rise, supported in part by improved fundamentals, and commercial real estate lending by banks accelerated in recent quarters
- The ratio of private nonfinancial sector credit to gross domestic product remains below estimates of its long-term upward trend
- Debt growth in the nonfinancial business sector has slowed in recent months, particularly among speculative-grade and unrated firms.
So… what “less supportive financial conditions”? Well, it was not all roses. Here is what according to the Fed is not working lately.
- Broad equity indexes have declined significantly since July 2015, and forward price-to-earnings ratios have fallen to a level closer to their averages of the past three decades.
- Yields on longer-term Treasury securities decreased over that period, and estimates of term premiums remained low. Because many assets are priced based on Treasury yields, their low level continues to pose a risk to valuations of assets that have lower-than-average earnings yields
- leverage [among speculative-grade and unrated firms] firms has risen to historical highs, especially among those in the oil industry, a development that points to somewhat elevated risks of distress for some business borrowers.
In other words, it’s all about the market, the record junk (and all other) leverage. Which begs the question: why did Yellen not do a “full Draghi” and relent to future rate hikes as some had expected she would, thereby removing the very “financial condition” which is so troubling the Fed. Oh yes, because that would mean the Fed joins the BOJ and the ECB in the club of central banks who have now lost credibility.
Which also explains why the Fed has been trapped ever since the summer of August 2014, when it started pushing the dollar higher, slamming the global economy and markets, and as DB’s Dominic Konstam reported yesterday, unleashed a giant central bank liquidity run.
Ironically, while not mentioned in the MPR, the biggest threat to the Fed is… the Fed.
Here is the full section from the Report:
Developments Related to Financial Stability
Financial vulnerabilities in the U.S. financial system overall have continued to be moderate since mid-2015. Regulatory capital and liquidity ratios at large banking firms are at historically high levels, and the use of short-term wholesale funding remains relatively low. Debt growth in the household sector continues to be modest and concentrated among borrowers with strong credit histories. Some areas where valuation pressures were a concern have cooled recently; in particular, risk premiums for below-investment-grade debt have widened. However, high leverage of nonfinancial corporations makes some firms highly vulnerable to adverse developments, such as lower oil prices or slowing global growth.
Vulnerabilities owing to leverage and maturity transformation in the financial sector remain low. Regulatory capital ratios at U.S. banking firms increased further in the third quarter of 2015, and holdings of high-quality liquid assets at banking firms also remain at very high levels. In addition, some of the largest domestic banks have reduced their reliance on potentially less stable types of short-term funding. The aggregate delinquency rate on bank loans declined to its lowest level since 2006, though delinquency rates on loans to the oil and gas industry, which account for a small share of most banks’ portfolios, have increased. Bank underwriting practices in the leveraged loan market have improved, on balance, over the past year but occasionally still fall short of supervisory expectations. Moreover, domestic banking firms have only limited exposure to emerging market economies. However, developments in foreign economies and financial markets, particularly an escalation of recent volatility or a worsening of the outlook for China, could transmit risks through indirect financial linkages.
Net secured borrowing by dealers, primarily used to finance their own portfolios of securities, continued to decrease and is near historical lows, while securities financing activities aimed at facilitating clients’ transactions also remain at low levels. The latter is consistent with reports that dealers have tightened price terms for securities financing and derivatives. The volume of margin loans outstanding—an important component of overall leverage used by hedge funds—appears to have moderated. Short-term funding levels remain relatively low, though reforms aimed at reducing structural vulnerabilities in those markets are still being implemented.
Overall asset valuation pressures have eased. Corporate bond spreads increased notably and are now above their historical norms (figure A). Those spreads appear to have risen by more than the compensation required for higher expected losses, suggesting risk premiums have also increased. Issuance of speculative-grade bonds and leveraged loans has slowed significantly, which also could reflect, in part, an increase in investors’ risk aversion. Despite the volatility, most indicators of liquidity conditions in corporate bond markets, such as trading volumes and bid-asked spreads, deteriorated only slightly. Nonetheless, the suspension of redemptions in December by a high-yield bond mutual fund that had a high concentration of very low-rated debt and had experienced persistent outflows highlighted a vulnerability at open-end mutual funds that offer daily redemptions to investors while holding less-liquid assets.
Commercial real estate prices continued to rise, supported in part by improved fundamentals, and commercial real estate lending by banks accelerated in recent quarters. However, spreads on securities backed by commercial mortgages widened further and bank lending standards reportedly have tightened since July, suggesting that financing conditions have become a little less accommodative. In addition, late last year, federal banking regulators issued a joint statement reinforcing existing guidance for prudent risk management in that sector. Residential home prices also continued to increase. However, price-to-rent ratios do not suggest that valuations are notably above historical norms, and residential mortgage debt growth remains minimal.
Broad equity indexes have declined significantly since July 2015, and forward price-to-earnings ratios have fallen to a level closer to their averages of the past three decades. Yields on longer-term Treasury securities decreased over that period, and estimates of term premiums remained low. Because many assets are priced based on Treasury yields, their low level continues to pose a risk to valuations of assets that have lower-than-average earnings yields. However, in December, the Federal Reserve’s increase in the target range for the federal funds rate did not result in significant changes in longer-term interest rates or their volatility.
The ratio of private nonfinancial sector credit to gross domestic product remains below estimates of its long-term upward trend, reflecting subdued levels of household debt. Debt growth in the nonfinancial business sector has slowed in recent months, particularly among speculative-grade and unrated firms. However, leverage of such firms has risen to historical highs, especially among those in the oil industry, a development that points to somewhat elevated risks of distress for some business borrowers.
And this is how the Fed believes it is satsifying its macroprudential obligations, by taking the following steps to “improve the resiliency of the financial sector”
As part of its effort to improve the resilience of financial institutions and overall financial stability, the Federal Reserve Board has taken several further regulatory steps. First, the Board finalized a rule that increases risk-based capital requirements for U.S. global systemically important bank holding companies (G-SIBs). The applicable surcharges are calibrated based on the systemic footprint of each U.S. G-SIB so that the amount of additional capital a firm must hold increases with the costs that its failure would impose in terms of U.S. financial stability. The G-SIB surcharge rule is designed to ensure that U.S. G-SIBs either hold substantially more capital, reducing the likelihood that they will fail, or choose to shrink their systemic footprint, reducing the harm that their failure would do to the financial system.
Second, the Board announced that it is seeking public comment on its proposed framework for setting the Countercyclical Capital Buffer (CCyB) and voted to affirm the CCyB amount at the current level of 0 percent—consistent with the continued moderate level of financial vulnerabilities. The buffer is a macroprudential tool that can be used to increase the resilience of the financial system by raising capital requirements on internationally active banking organizations when there is an elevated risk of above-normal losses in the future. The CCyB would then be available to help those banking organizations absorb shocks associated with worsening credit conditions, and it may also help moderate fluctuations in the supply of credit. In releasing the framework for comment, the Board consulted with the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency. Should the Board decide to increase the CCyB amount in the future, banking organizations would have 12 months before the change became effective, unless the Board established an earlier effective date.
Third, the Board issued for public comment a proposed rule that would impose total loss-absorbing capacity and long-term debt requirements on U.S. G-SIBs and on the U.S. operations of certain foreign G-SIBs.4 The proposal would require each covered firm to maintain a minimum amount of unsecured long-term debt that could be converted into equity in a resolution of the firm, thereby recapitalizing the firm without putting public money at risk. The proposal would diminish the threat that a G-SIB’s failure would pose to financial stability and is an important step in addressing the perception that certain institutions are “too big to fail.”
Finally, the Board, acting in conjunction with other federal regulatory agencies, issued a final rule imposing minimum margin requirements on certain derivatives transactions that are not centrally cleared. The swap margin rule will reduce the risk that derivatives transactions would act as a channel for financial contagion and, by imposing higher margin requirements on uncleared swaps than apply to cleared swaps, will incentivize market participants to shift derivatives activity to central clearinghouses.
Looking at the CDS of Deutsche Bank, for some reason we don’t feel too comforted.
via Zero Hedge http://ift.tt/1Q7jrxq Tyler Durden