Bonds, junk bonds, spreads, commercial real estate, leveraged loans, over-leveraged companies… all get named as risks to the banks. This is why tightening will continue.
“If we have learned anything from the past, it is that we must be especially vigilant about the health of our financial system in good times, when potential vulnerabilities may be building,” explained Federal Reserve Board Governor Lael Brainard in a speech in Washington, D.C., this morning.
This was a reference to a time-honored banker adage, now mostly forgotten after nearly nine years of easy money: Bad deals are made in good times.
Brainard fills one of the seven slots on the Board of Governors. Two slots are filled by Chairman Jerome Powell and by Randal Quarles. Four slots remain vacant, waiting for Trump appointees to wend their way. She is a strong “dove” in the world of central banks, and she just pointed at why the Fed is tightening – and will continue to tighten: the Everything Bubble.
After rattling off a litany of indicators showing why and how the economy’s “cyclical conditions have been strengthening,” she added this gem, there being nothing like Fed-speak to make your day: “Currently, inflation appears to be well-anchored to the upside around our 2 percent target.”
“Well-anchored to the upside” of the Fed’s target – and then she moved on to the “signs of financial imbalances.”
“Financial imbalances,” in Fed speak, are asset bubbles, a phenomenon when prices are out of whack with economic reality. In a credit-based economy, assets are collateral for debt. And inflated asset prices put the financial system, meaning the lenders, at risk when those asset prices deflate. Since the Fed has to take care of the financial system, and since it blew up so wonderfully last time due to asset bubbles deflating, the Fed is right to be worried about it. At first the hawks, the rare ones; and now even the doves.
And she goes on, sticking all the while to the central banker rule of never calling anything in front of them a “bubble.” They say, prices are “elevated”:
Our scan of financial vulnerabilities suggests elevated risks in two areas: asset valuations and business leverage.
First, asset valuations across a range of markets remain elevated relative to a variety of historical norms, even after taking into account recent market volatility.
In other words, even after the mini-selloff since the end of January, prices are still too “elevated.” And then she goes into my favorite metrics, the bond market bubble where investment-grade yields are low and junk-bond yields are ludicrously low, with paper-thin spreads or risk premiums that don’t pay investors for the massive risks they’re taking, the bubble in “leveraged loans” and collateralized loan obligations (CLOs), and the bubble in commercial real estate, particularly in multifamily and industrial:
Corporate bond yields remain low by historical comparison, and spreads of yields on junk bonds above those on comparable-maturity Treasury securities are near the lower end of their historical range.
Spreads on leveraged loans and securitized products [CLOs] backed by those loans remain narrow.
Prices of multifamily residential and industrial commercial real estate (CRE) have risen, while capitalization rates for these segments have reached historical lows.
It is rare to hear a Fed governor, and a dove in particular, list some of the biggest elements in the Everything Bubble as a concern. And the concern is not how to maintain it and keep it inflated; but how to tamp down on it gradually.
And then she gets into “business leverage,” in other words, companies with too much debt – which has turned into a record problem:
Second, business leverage outside the financial sector has risen to levels that are high relative to historical trends. In the nonfinancial business sector, the debt-to-income ratio has increased to near the upper end of its historical distribution, and net leverage at speculative-grade [junk-rated] firms is especially elevated.
I added the bold below:
As we have seen in previous cycles, unexpected negative shocks to earnings[though they’re actually not unexpected, as we’ve seen in the brick-and-mortar meltdown] in combination with increased interest rates could lead to rising levels of delinquencies among business borrowers and related stresses to some banks’ balance sheets.
OK, already happening. Chapter 11 bankruptcies spiked 63% in March from a year ago and have hit the highest level since April 2011. The credit cycle has already begun to turn.
So Brainard has just outlined in her elegant and soft-spoken Fed-speak manner a big part of the Everything Bubble and the risks its deflation poses to the banking system.
She then explains that the banks are in good shape now, very profitable, with plenty of liquidity, and with large capital buffers, and are much more tightly regulated than before the Financial Crisis, so that they can take a good wallop from their borrowers without collapsing. This leads her to her next topic, with stark references to the Financial Crisis: Now – the good times – is not the time to back off from regulation and it’s not the time to lower capital requirements and reduce liquidity rules.
But it is the time to tamp down on these “elevated” asset prices that are putting banks at risk.
There appears to be now a near-consensus at the Fed about this. The keyword is “gradual.” Nearly every time the Fed says anything big, it has “gradual” in it. And this is why the tightening will continue though it may become slightly less “gradual.” But because it’s still so gradual, it will go on for a long time – with the goal of deflating the Everything Bubble very “gradually.” That would be the ideal scenario. No economic upheaval, no sudden collapse in asset prices, but also no spike in inflation that would push the Fed to abandon the “gradual” approach and go for some kind of monetary shock. Just smooth gliding at ever lower altitudes for many years. That’s the best-case scenario after nearly a decade of rampant asset price inflation generated by experimental monetary policies.
The corporate bond market, particularly the junk-bond market, is happily dreaming in La-la-land till the rude awakening. Read… Junk Bond Market Still in Total Denial, Fighting the Fed