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The Financial Times, Bloomberg, and the Wall Street Journal all gave enough different spins on the latest Fed Financial Stability report, which the central bank issues twice a year, that it seemed useful to give it a look. We’ve embedded it at the end of the post for your convenience.
The entire document is worth a look, since it has sections that may appeal to various interests, such as a post-mortem of the March 2020 Treasury market upheaval, a discussion of the risk of non-cash collateral at central counterparties, and meme stocks. But the part the press focused on was “Near-Term Risks to the Financial System,” which starts on page 59.
Regular readers would hopefully have internalized the Fed’s framework:
- Elevated valuation pressures are signaled by asset prices that are high relative to economic fundamentals or historical norms and are often driven by an increased willingness of investors to take on risk. As such, elevated valuation pressures imply a greater possibility of outsized drops in asset prices.
- Excessive borrowing by businesses and households leaves them vulnerable to distress if their incomes decline or the assets they own fall in value..
- Excessive leverage within the financial sector increases the risk that financial institutions will not have the ability to absorb even modest losses…
- Funding risks expose the financial system to the possibility that investors will “run” by withdrawing their funds…
I suspect experts like Steve Keen and Richard Vague would be more than a tad frustrated by this. Normally, in academic work and even financial reports, the ordering of items signals which is to be taken as most important. It’s distressing to see the central bank depict itself as concerned with asset price levels, and even worse, broadly stated.
Investors are supposed to be grown-ups and know that they are taking risk, as in the possibility of loss. Financial economics posits the existence of a risk-return tradeoff, that investors take more risk in the hope of getting better results.
So what a central bank ought to be concerned about is leverage of assets, and not asset prices per se. Recall that we had an enormous dot-com bubble, but in public stocks, and the regulators have strict limits on margin loans. When it imploded, there was no damage to the financial system (amusingly, there was to players that had managed to leverage themselves to the mania by taking Internet stocks in lieu of cash….like McKinsey, which had to write off $200 million. It also had to shrink its headcount by nearly 50% in two years in North America due to having greatly increased staffing to service dot-com panicked clients and serve clients who had eyeballs rather than cash).
But instead, the Fed sees itself as the guardian of asset prices generally, irrespective of the degree of blowback to financial institutions, because confidence fairy. The continuation of the Greenspan-Bernanke-Yellen put is what created these greatly attenuated valuations, but you never hear a hit of agency in how the Fed characterizes its “Gee, asset prices are pretty high” observation.
Most experts who have taken a hard look at crises have found that high levels of private sector borrowings, particularly by households, is what sets the stage for a financial crisis.
Another financial crisis risk factor, oddly absent from the Fed’s list, is high levels of international capital flows. An 800 year study of financial crises by Ken Rogoff and Carmen Reinhart found that high levels of international capital movements were strongly correlated with rising and increasingly severe financial crises. When their study came out, it received all sorts of approving noises. But no one was willing to act on its obvious implications and start imposing capital controls, or at least increase frictions through transactions taxes. Can’t wind the clock back on the supposed progress of ever more globalization and financialization.
Now let’s turn to the list of current worries. According to the Financial Times and Bloomberg, it’s China. Their headlines, respectively: Fed warns ailing China real estate sector poses risks to US economy and China Property Stress Spurs Fed Warning as Bond Losses Widen .
While these headlines are narrowly correct, they give the impression that the Fed singled out China as representing a distinctively seroius yellow peril to America’s economic health. In fact, China is listed third. Here they are, in order:
A potential worsening of the public health situation may result in a reduction in business and household confidence, negatively affecting future economic activity and financial vulnerabilities…
A sharp rise in interest rates could slow the pace of economic recovery and lead to sharp declines in asset valuations and stresses at financial institutions, businesses, and households…
Stresses in China’s real estate sector could strain the Chinese financial system, with possible spillovers to the United States….
Adverse developments in other emerging market economies spurred by a sudden and sharp tightening in financial conditions could also spill over to the United States…
In Europe, a slower-than-expected recovery could trigger financial stresses and pose risks to the United States because of strong transmission channels
Moreover, if you read the section on China, you get the feeling that the Fed doesn’t really have a theory as to how blowback from China might occur, just that China is so big, if it went really pear-shaped, it couldn’t not affect the US:
In China, business and local government debt remain large; the financial sector’s leverage is high, especially at small and medium-sized banks; and real estate valuations are stretched. In this environment, the ongoing regulatory focus on leveraged institutions has the potential to stress some highly indebted corporations, especially in the real estate sector, as exemplified by the recent concerns around China Evergrande Group. Stresses could, in turn, propagate to the Chinese financial system through spillovers to financial firms, a sudden correction of real estate prices, or a reduction in investor risk appetite. Given the size of China’s economy and financial system as well as its extensive trade linkages with the rest of the world, financial stresses in China could strain global financial markets through a deterioration of risk sentiment, pose risks to global economic growth, and affect the United States.
Translation: the Fed does not see any direct transmission mechanism from China’s financial systems to ours. However, a domestic financial crisis could produce a sharp drop in trade. Suppliers in China are already getting slow payments on receivables, and many borrow to cover that. That contraction could blow back to other economies and their banks, and potentially propagate to the US, or more likely, directly whack confidence. Recall that there have been a couple of episodes of sharp downdrafts in Chinese financial markets, which typically lasted only two weeks, and markets abroad dropped in sympathy.
In fairness, one could argue that Bloomberg was using the Fed report as a hook for an update on souring conditions in China. From its article:
The cash crunch is worsening by the day. The yield on a Bloomberg index of Chinese junk dollar bonds — dominated by property firms — has surged toward 24%. Kaisa Group Holdings Ltd., which said last week it missed payments on wealth products, was downgraded further into junk by Fitch Ratings on Tuesday.
The selloff has spread to higher-grade issuers such as Country Garden Holdings Co., while even a company controlled by China’s government has seen its bonds slump. Spreads on the nation’s investment-grade bonds over Treasuries widened the most since April on Tuesday.
So Bloomberg only discussed the China section. The Financial Times led with China and devoted six out of fourteen paragraphs to it. Three were on meme stocks even though the Fed did not cite them as a “near-term risk” but instead had a special section them. The article inaccurately said the Fed’s domestic warnings were only a sharp interest rise and its impact on risky assets and housing. No mention whatsoever of the lead item, Covid risk.
By contrast, the Wall Street Journal put Covid front and center: Fed Says U.S. Public Health Among Biggest Near-Term Risks to Financial System The Journal did not mention China but stressed that Fed officials were concerned about elevated asset prices.
What is striking is that the Fed report mentioned supply chain problems all of once (to its credit, the Journal did pick up on that). From the Stability Report:
A possible deterioration in the public health situation could slow the recent economic recovery, particularly if widespread business closures returned and supply chains were further disrupted.
Note that the central bank sees supply chain problems as not a danger at their current level, nor a sufficient risk to create damage to the economy absent a resurgence of Covid.
Yet there is no indication the log jam in West Coast ports is getting any better. Lambert cited a Business Insider piece yesterday in which an intrepid reporter took a boat ride to see what was happening, and things were not better than on the earlier boat ride that described how little action there was.
We are getting reports that the crunch may be about to turn acute. As we report in Links, rural hospitals in flyover are not able to get crutches or walkers due to aluminum shortages. It’s easy to dismiss that more as a function of problems with trucks and trains, but one reader says a CEO in the industry says that the problem is not only widespread but also acute, and will go critical within two months. Even though aluminum is also recycled domestically, that equipment is fussy and prone to breakdown, and parts for them are in very very short supply. We are also hearing warnings about copper due to high quit rates in recycling plants and mines that rely on seasoned personnel where it is hard to bring on new staff. Operators are attributing it to vax resistance; the men work in close conditions in poor ventilation and know or believe they have already gotten Covid and resent being asked to take a shot now. The claim is they are getting out now while the job market is strong.
Mind you, these reports are anecdata, and aside from the story on shortages at one hospital, not independently corroborated. But this is the sort of story that could easily fall through the cracks. The financial press is very hollowed out, focused on big markets and big industries. Domestic processors are likely way below their radar. And insiders would not want to sound alarms if all that would do is cause buying panic.
So please be on the lookout for supporting or contrary data points. Either of these shortages would be a very big deal if they come to pass.00 financial-stability-report-20211108