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Banking on financial stability

admin | November 1, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The Fed’s job of ensuring financial stability almost guarantees the central bank will remain a force in the markets equal to if not greater than any other, and it also implies real limits to systemic risk. In January the Fed countered tighter financial conditions by remapping its own policy path and in September started countering frictions in the repo markets. “We do financial stability,” Fed Chair Powell noted after the most recent meeting of the federal open market committee. Investors should take that seriously.

The credit markets do seem to be taking the Fed seriously. Investment grade and high yield spreads are running around their averages since 2011 despite slowing US and global growth and despite risks from trade tensions and Brexit. This is also true despite a decline in the average rating of issuers. One interpretation of this is that credit investors are relying on the Fed to successfully counter risk to the economy from any quarter, including signs of stress in the credit markets themselves. An economy that stabilizes around 2% growth—the most likely path by far—is a goldilocks market for credit.

Exhibit 1: Credit spreads stand near longer averages despite growth risks

Source: Bloomberg, Amherst Pierpont Securities

The Fed has shown repeated willingness to do financial stability. The doing mostly gets done through regulation of bank capital and liquidity, but markets matter, too. Beyond the heroic efforts during and immediately after the 2008 financial crisis, the Fed also countered the 2013 taper tantrum and the 2014 flash crash in Treasury debt. The distinction between the real and financial economies has disappeared after the crisis showed financial conditions have real impact. The Fed’s purview now arguably includes any risk that broadly threatens to weaken banks or markets or the allocation of capital.

Investors have long imagined a Fed put on rates, but the list of potential risks to financial stability arguably is much longer. Stress in corporate credit markets could add up to stability risk. Stress in private markets for residential mortgage credit could make the list. Stress in repo and funding clearly is on the list. Failure in bank or market technology might be on the list as well, along with other possibilities.

At the extreme, any investor in any product with systemic risk exposure has to consider the potential for the Fed to counter the risk. The willingness to counter systemic risk makes the Fed a systemic market factor itself, equal to any other factor such as growth, inflation, interest rates, liquidity, credit and so on. The Fed’s stability role arguably reduces the risk and the risk premiums from any of these factors. In that regard, the market past may not be a good guide to the market future.

That is not to say investors should expect the Fed to counter all risk. Small or idiosyncratic risk is on its own. To get the Fed’s attention, it’s go big or go home.

Over time, one unintended consequence of the Fed’s own stability role may be to make the market more reliant on the Fed. If investment managers increasingly look to the Fed to buffer systemic risk, those portfolios will likely end up less prepared if risk materializes. Risk management slowly becomes centralized, and the Fed may have to work harder and more often to contain financial risk.

The markets already are leveraged on the decisions of the Fed. That only looks to get more pronounced and make the market more sensitive to Fed policy. All along the way, however, takers of systemic risk are likely to get well compensated.

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The view in rates

The Fed has likely delivered its last rate cut for 2019 and brought its mid-course correction to a temporary end. The bar for any move higher or lower looks high. That should keep the Fed on hold for a long time, likely through next year at least. Rates in the front end of the curve look likely to be pinned down, but the long end of the curve should be sensitive to the Fed view of growth and inflation, including the influences from a slowing global economy. For now, look for the curve to flatten and volatility to drop.

The view in spreads

Investment grade and high yield credit broadly should continue to tighten. The weakest part of the leveraged loan and CLO markets could widen, but that’s an idiosyncrasy of heavy issuance of weak loans into a market dominated by CLO ill-equipped to absorb the supply. Investors across credit markets nevertheless should keep an eye on liquidity risk in the fourth quarter of the year. Trading volumes usually dip, bid-ask typically widens, financing tightens. Less liquid names in investment grade and high yield should widen to more liquid names, and more complex products should widen to simplier. MBS has lagged credit and should continue to trade at soft spreads largely due to heavy volumes of refinanced loans flowing through the market. MBS spreads should stay soft through the balance of the year and start to tighten thereafter.

The view in credit

Slowing global growth will almost certainly catch the most leveraged credits, and spreads in leverage loans reflect some of that concern. Leverage in investment grade corporate credit also has trended up this year, but an accommodative Fed has provided a buffer. As for the US consumer, low unemployment, high income and high aggregate household wealth leave consumer balance sheets in good shape. The readiness of the Fed, the ECB and other central banks to backstop growth makes broad recession unlikely. The weakest credits should feel a slowing economy, but without recession, the averages should remain good.