Fed raises rates

Yesterday, US Federal Reserve Board open market committee raised interest rates for the first time in a year from 0.25-0.5% to 0.5-0.75%. Moscow believes the event doesn’t influence the ruble rate dynamics even in a short-term period.

The Australian analyzed the situation ahead of the Fed’s decision: If you wanted a checklist for where the most significant risks to the global economy and financial system might lie, the US Office of Financial Research would be a good place to start. It is no great surprise that its latest financial stability assessment highlights global factors and market risks as the biggest threats.

The OFR, an independent unit with US Treasury that was established in the wake of the financial crisis, assess the overall level of risks to financial stability in the US as “medium” in the latest report it issued overnight. It sees, however, downside risk to the world’s key economy and financial system from low levels of global growth, a strong dollar and instabilities and uncertainties in the eurozone. It’s also concerned about elevated risks within emerging economies after rapid credit growth in the post-crisis period.

It’s the discussion of market risks, however, that is probably most topical and discomforting. As it notes, US equity valuations are high, having reached levels only seen previously ahead of the three largest equity market declines of the last century. And commercial real estate prices are high, with capitalisation rates close to record levels.

“A price shock in one of these markets could threaten US financial stability if the assets were widely held by entities that use high levels of leverage and short-term funding,” the OFR’s report says. “A price shock that coincided with a sharp increase in US corporate defaults would amplify the risks.’’

Over eight years of ultra-low interest rates in the major economies duration in US bond portfolios was near the top of its long-term range, leaving investors open to heavy losses from even moderate increases in interest rates.

As it said, low long-term rates might stimulate an economy but they can undermine financial institutions’ stability because of their limited ability to reprice their liabilities even as asset yields fall. Then impact of low and negative rates on financial institutions — banks and insurers in particular — has been a major talking point for regulators this year. The OFR says it is concerned about the market risks for US banks and insurers.

It’s also concerned about the levels of US non-financial corporate credit risk, which it says remain high as debt levels continue to grow rapidly and are now surpassing 2007 levels. “Covenant-lite” lending has also grown rapidly since 2008 and now accounts for two-thirds of outstanding corporate leveraged lending.

US companies had increased their leverage in recent years by borrowing to buy back their shares. Non-bank financial institutions were also highly-leveraged, with the 10 largest hedge funds having average leverage of 15:1, with much of the leverage obtained via short-term debt.

It is the combination of sky-high equity and property values with high levels of leverage and short-term funding that pose the real threat of something very unpleasant and disruptive occurring if there were some trigger event that occurred either offshore or within the US.

As the OFR says, over the past three decades corrections in corporate debt, equity prices and commercial real estate prices have often coincided, with each spike in corporate default rates since 1980 coinciding with an equity market sell-off and each correction in real estate markets coinciding with a surge in default rates for corporate bonds and commercial real estate debt.

Continued low rates, it said, have probably strengthened the links between these markets, creating incentives for businesses to take on more debt and investors to pay more for higher-yielding assets. Persistently low rates encourage increased risk-taking and rates have now been at unprecedented low levels for a very long time.

Sharp declines in equity and property values and a rise in debt defaults would create a rising risk to financial stability. While post-crisis reforms have made banks, particularly the systemically important ones, more resilient, “shadow” banks are the largest sources of finance for US companies and households. Shadow banking credit has grown by more than $US1.2 trillion since 2011.

The tough new capital and liquidity regimes global banking regulators have imposed — and continue to tighten — since 2008 could be circumvented and undermined by implosions in the less-regulated sectors of the global system.

The report has been issued a day ahead of a US Federal Reserve Board open market committee meeting that is expected to raise US official rates for the first time in 12 months, and only the second time since the crisis. The market is assigning a 95 per cent probability to a 25 basis point increase in the federal funds rate.

There is also a deepening discussion about what a Trump presidency, with its deficit and debt-funded high-growth ambitions, might mean for the Fed’s stance in future.

The likelihood is that faster growth in a US economy already growing at reasonable levels, and with unemployment within the Fed’s target levels, would result in higher inflation and a more rapid normalisation of US rates.

Give that until the recent aggressive bond sell-off global yield curves were very flat, the risk of very large losses on longer-dated bonds if rates were to rise more rapidly than the market anticipated — and the impact of rising rates on equity prices and the servicing of corporate debt — would also rise significantly.

Until relatively recently, when it became more obvious that the US rate cycle was actually nearing an inflection point — and when the election of Donald Trump, with his aggressively expansionist economic agenda but a protectionist trade agenda created a wildcard for markets and companies to process — there was an inherent assumption built into, and priced into, investor and corporate behaviours that central banks would leave rates at ultra-low levels indefinitely.

That conviction has been challenged as this year has progressed, with bond markets showing the initial signs of a shift towards the repricing of risk that is a necessary precondition for an eventual normalisation of market settings and returns, albeit over a time frame probably measured, if all goes relatively smoothly, in years rather than months.

The kind of shock to the system the OFR identifies because of the tight correlation of the major assets classes and the extent of leverage in the system could, of course, accelerate the process in a rather more dramatic and traumatic way.