Fed Financial Stability Report Highlights Risks

Federal Reserve Chairman Jay Powell ironically probably felt a tinge of relief upon seeing the non-farm payrolls number. Why? Because it gives him cover to continue the course the Fed has been pursuing of near-zero rates and copious asset purchases Minneapolis Governor and PIMCO veteran Neel Kashkari commented in the wake of the jobs number that now was absolutely not the time to be raising rates. He also poignantly added that he has ‘zero sympathy’ for Wall Street critics of the Fed. We sincerely hope from the bottom of our hearts that he didn’t hurt any of your feelings or dash your expectations for sympathy.

This is all pretty well and good for the Fed given that by many other signs other than today’s jobs report the Economy is well within the stride of re-opening. First quarter productivity rose 5.4% which blew away the expectations of only 4.3%. US junk-bond yields dropped to an all-time low of 3.88% on Monday. Spreads hit their tightest level in well over a decade at (+289 bps). While the Fed got an immediate reprieve because of the jobs report, inflation expectations and bond vigilantes are unlikely to make the Central Bank’s life easy over the coming quarters as the economy continues to get red hot.

The strong rally in credit continues across all buckets. Issuance is on track to be the busiest first half ever on record. Currently we are only $5 billion short of the $211 billion record and there’s two full months to go. Bullish indicators are so plentiful many had speculated the Fed would be forced to begin talking about raising rates. Secretary Yellen even said something to the effect, which was probably unwelcome uptown at the Fed.

The Fed’s Financial Stability Report also showed an overwhelmingly strong picture in many respects. Banks remain very, very well capitalized. Leverage levels are very low among broker dealers. Household debt is manageable and loans are generally being paid back by households and businesses at historically high rates. The consumer balance sheet is very strong, buoyed by government stimulus.

The Fed issued a report on Thursday that warned of the risks of rising asset prices, including the boom in stock prices. In a statement that seems rather obvious to us, the Central Bank stated that “Asset prices may be vulnerable to significant declines should risk appetite fall. The semi-annual Financial Stability Report shouldn’t be taken with too much alarm. The job of the regulatory agencies that compile this report is to assess potential threats to financial stability from multiple vantage points but also well in advance. The report of course also cited COVID-19 and the potential for the spread of variants as a major potential risk.

Another strong point in the Financial Stability Report noted that many efforts have been taken to prevent contagion like occurred from the ABS market in 2008 from repeating itself. The Fed specifically mentioned that assets which may be considered speculative, like cryptocurrency, do not pose a significant risk to financial stability, outside the individuals who choose to take risk investing in this area.

Asset purchases continued at a pace of $40 billion a month for MBS and $80 billion a month for Treasuries. The benchmark yield on the 10 year is 1.579%.

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