The Federal Reserve used its first-ever financial stability report to warn primarily of the dangers lurking in corporate debt, as it made the case that the banks it regulates are strongly capitalized.
The Fed said valuation pressures are generally elevated, with investors exhibiting a high tolerance for risk taking with business debt-related assets. It found that the debt owned by businesses relative to GDP historically high, with signs of deteriorating credit standards.
All that said, the Fed also found less worrisome aspects in the financial system. Household borrowing has rose roughly in line with income, the nation’s largest banks are strongly capitalized and have more liquid assets, broker-dealer leverage is below pre-crisis levels, insurers have strengthened their financial position, and money market funds are less vulnerable to runs.
The Fed said corporate bond yields over comparable-maturity Treasury securities are near the lower end of their historical range.
“Low expected default rates cannot completely explain the low level of bond spreads; the excess bond premium, an estimate of the gap between bond spreads and expected credit losses, is also near the lower end of its historical distribution,” the Fed said.
Spreads on leveraged loans — a segment of the market that Sen. Elizabeth Warren, a Massachusetts Democrat, has recently raised concerns about — have widened a bit over the past few months but remain in the lower end of their range since the crisis. The Fed also said there’s evidence lenders have become more willing to extend loans with fewer credit protections to higher-risk borrowers.
Growth in riskier forms of business debt—high-yield bonds and leveraged loans—which had slowed to zero in late 2016, rebounded in recent quarters, the Fed pointed out, with what it calls “risky debt” up 5% over the year ending in the third quarter of 2018 and over $2 trillion in size.
While the Fed’s asset warning were focused on debt, it said equity prices are “somewhat high” relative to forecast earnings. The S&P 500
forward price-to-earnings ratio remains above its median value over the past 30 years, while the gap between the forward earnings-to-price ratio and the 10-year real Treasury yield
is still well above the dot-com era levels.
On house prices, the Fed found the current price-to-rent ratio somewhat higher than the long-run trend and that relative to household income, “somewhat elevated” valuation pressure.
As to near-term risks, the Fed flagged the uncertain terms around Brexit as well as concern over Italy’s finances, which it said could lead to market volatility, direct credit exposure, a worsening European economy and dollar appreciation. Problems in China and other emerging market economies could spill over to the U.S., the Fed said.
Concerns over trade and other geopolitical tensions could result in a drop in asset prices.
The Fed’s findings aren’t wildly different from similar reports put forward from the International Monetary Fund and the Treasury Department’s Office of Financial Research. However, the Fed did not come to an overall conclusion about financial stability, as did the OFR for instance.
The Fed report did not touch at all on fiscal issues. Fed Chairman Jerome Powell has noted on repeated occasions that the U.S. is on an unsustainable fiscal path.
The Fed intends to produce the report twice per year.