US economy

Fed flags hard Brexit and Italian debt as near-term risks to US 


The Federal Reserve has flagged a hard Brexit and Italian sovereign debt sell-off as near-term risks to the US financial system, in a broad-ranging assessment of the country’s financial stability. 

A UK exit from the EU without a withdrawal agreement or an intensification of sovereign debt concerns in the euro area could trigger market volatility and a “sharp pullback” by investors from riskier assets similar to that seen after the 2016 UK referendum, the Fed said.

The Fed’s report also highlighted the risk of an escalation of trade tensions or geopolitical uncertainty, which could lead to a decline in investors’ risk appetites and trigger a “particularly large” drop in asset prices given the sharp run-up in market valuations.

The assessment came in a new Financial Stability Report from the Fed that highlighted “elevated” valuations in a number of markets. It also emphasised the strongly capitalised state of the banking system and ample liquidity being held by lenders.

The inaugural report is the latest sign of the Fed’s increased focus on financial stability following the crisis, as some policymakers flag hazards stemming from years of ultra-low interest rates. 

The Fed said overall vulnerabilities in household credit are currently “moderate”, with household debt levels remaining contained relative to incomes.

It also highlighted rising risks within business lending. Business-sector debt is at a “historically high” level relative to gross domestic product, the report found, and there are signs of deteriorating credit standards.

“In addition, recently, debt has been growing fastest at firms with weaker earnings and higher leverage,” the Fed said. Leveraged loans have seen by far the quickest expansion among the various classes of credit examined, recording average annual growth of 15 per cent between 1997 and the second quarter of 2018.

Risky business debt — which includes high-yield bonds and leveraged loans — rose 5 per cent in the year ending in the third quarter of 2018 and now stands at over $2tn. The share of bonds with the lowest investment-grade rating has reached near-record levels, the Fed added. Firms with high leverage, high interest expense ratios and low earnings and cash holdings have been boosting their debt loads the most. 

The analysis comes amid broader worries about corporate lending. Last month Janet Yellen, the former Fed chair, told the FT that the US needs to deal with a “huge deterioration” in the standards of corporate lending instead of focusing on deregulation. High leverage has been associated in the past with sharp retrenchment by businesses during downturns. 

“Given the valuation pressures associated with business debt noted in the previous section, such an increase in financial distress, should it transpire, could trigger a broad adjustment in prices of business debt,” the Fed’s report said. “That said, with interest rates low by historical standards, debt service costs are at the lower ends of their historical ranges, particularly for risky firms, and corporate credit performance remains generally favourable.”

The Fed also flagged up elevated asset prices relative to their historical ranges across a number of markets including high-yield corporate bonds, equities, commercial real estate and farmland. It stressed that the biggest banks are strongly capitalised and leverage among broker-dealers is much lower than before the financial crash. 

“Reforms undertaken since the financial crisis have made the US financial system far more resilient than it was before the crisis,” the report said. 



READ SOURCE

Leave a Reply

This website uses cookies. By continuing to use this site, you accept our use of cookies.