Fed Warns Assets Could Suffer “Significant Declines” If Covid Is Not Contained

Fed Warns Assets Could Suffer “Significant Declines” If Covid Is Not Contained

Tyler Durden

Mon, 11/09/2020 – 16:59

While it’s a little odd to read about market and economic risks on the day the every major index hit an all time high (then slumped) amid expectations the economy is on its way to a full recovery thanks to some vaccine which may or may not be available in early 2021 and which half the population have sworn they will not take, moments ago the Fed published its latest semi-annial Financial Stability Report, in which it emphasized that risk assets could be hit if the coronavirus pandemic’s economic impact worsens in coming months, to wit: “the COVID-19 shock highlighted how vulnerabilities related to leverage and funding risk at nonbank financial institutions could amplify shocks in the financial system in times of stress.”

While “asset prices have generally increased since May, and, when adjusted for low interest rates, valuation pressures appear roughly in line with their historical norms”, the Fed warned that “uncertainty remains high, and investor risk sentiment could shift swiftly should the economic recovery prove less promising or progress on containing the virus disappoint.”

So worried is the Fed about the impact of covid that it dedicated the entire first section in its “near-term risk” section to covid, in which it said that “investor risk appetite and asset prices have increased in recent months but could suffer significant declines should the pandemic take an unexpected course or the economic recovery prove less sustainable.” The Fed also also warned that “the leverage of some nonbank financial institutions, such as life insurance companies and hedge funds, is high, exposing them to risks stemming from sharp drops in asset prices and funding illiquidity risks.

The effects of the pandemic have increased the vulnerabilities of the financial system to future shocks, including additional waves of substantial COVID-19 outbreaks

Most forecasters expect a moderate recovery in economic output in the United States and abroad following a global recession, but uncertainty surrounding this outcome is unusually high. The sharp slowdown in economic activity has disproportionately affected some businesses and households, and a further weakening in the balance sheets of those that are especially vulnerable could affect the financial system. Furthermore, monetary and fiscal policy tools have limited ability to moderate some dimensions of what is fundamentally a public health shock.

If the pandemic persists for longer than anticipated—especially if there are extended delays in the production or distribution of a successful vaccine—downward pressure on the U.S. economy could derail the nascent recovery and strain financial markets and financial institutions, particularly if many businesses are shuttered again and many workers are laid off and left without a normal income for a long period. If that were the case, a number of the vulnerabilities identified in this report could grow further, making them more likely to amplify negative shocks to the economy.

Investor risk appetite and asset prices have increased in recent months but could suffer significant declines should the pandemic take an unexpected course or the economic recovery prove less sustainable. Given the generally high level of leverage in the nonfinancial business sector, prolonged weak profits could trigger financial stress and defaults. In addition, a protracted slowdown could further harm the finances of even high-credit-score households, which could lead to defaults and place financial pressure on banks and other lenders. Broader solvency issues could impair the ability of some financial institutions to lend or induce increased asset sales and redemptions of withdrawable liabilities.

Although leverage remains at modest levels at banks, broker-dealers, and other financial institutions, the leverage of some nonbank financial institutions, such as life insurance companies and hedge funds, is high, exposing them to risks stemming from sharp drops in asset prices and funding illiquidity risks. Furthermore, prime MMFs and fixed-income mutual funds remain vulnerable to funding strains and sudden redemptions, as demonstrated during the acute period of extreme market volatility and deteriorating asset prices earlier this year. While government support has lowered the risk of adverse events associated with vulnerabilities in the nonbank sector, this sector would be vulnerable to funding risk should the government support be withdrawn.

Indicatively, the Fed is eyeing the following chart which shows that despite a record number of daily cases in the US, the number of corona-linked deaths have barely budged.

The smartest academics in the room also warned that “some segments of the economy, such as energy as well as travel and hospitality, are particularly vulnerable to a prolonged pandemic.” Furthermore, “within CRE, retail, office, and lodging properties exhibit the highest vulnerability” while commercial property values which have been especially sensitive to the pandemic, have already begun falling.

As a result, “uncertainty remains high, and investor risk sentiment could shift swiftly should the economic recovery prove less promising or progress on containing the virus disappoint.” Furthermore, some segments of the economy, “such as energy as well as travel and hospitality, are particularly vulnerable to a prolonged pandemic. Within CRE, retail, office, and lodging properties exhibit the highest vulnerability.”

As such, a vaccine that lessens the virus’s threat is vital to commercial real estate, which has much to gain if people begin working, shopping and traveling again at pre-Covid levels, the Fed said.

Besides covid, the Fed listed risks in the following categories:

  • Disruptions in global dollar funding markets remain an important source of risk
  • Stresses emanating from Europe also pose risks to the United States because of strong transmission channels…
  • … and adverse developments in emerging market economies with vulnerable financial systems could spill over to the United State

Additionally, as part of its market intelligence gathering for this report, the Federal solicited views from a wide range of contacts on risks to U.S. financial stability. From early September to mid-October, the staff surveyed 24 contacts at banks, investment firms, academic institutions, and political consultancies. As shown in the figure, respondents frequently cited concerns about U.S. political uncertainty as well as the risk of a COVID-19 resurgence generating renewed restrictions. Relatedly, a large share of respondents highlighted uncertainty surrounding the likelihood and efficacy of a policy response to economic weakness as well as concerns over the potential for increased insolvencies among nonfinancial corporates and small businesses.

The Fed also showed the size of the various asset markets discussed, with the largest asset markets are those for residential real estate, corporate public equities, CRE, and Treasury securities:

In what may be the most accurate thing it has ever said, the Fed warned that that vulnerabilities tend to build up over time – like for example the 11 years since the launch of QE – and are “the aspects of the financial system that are most expected to cause widespread problems in times of stress.” As a result, the Fed’s framework focuses primarily on monitoring vulnerabilities and emphasizes four broad categories based on research which include i) elevated valuation pressures, ii) excessive borrowings by businesses and households, iii) excessive leverage in the financial sector; and iv) funding risks.

According to Bloomberg, Fed Governor Lael Brainard, who has led the central bank’s stability reporting efforts and who is rumored to be Joe Biden’s top choice for Treasury Secretary, said the report shows that some of the same nonbank financial sectors that were troublesome in the 2008 meltdown are posing dangers in this crisis, which “highlights the importance of a renewed commitment to financial reform” although it is unclear how the Fed is reforming the system when it keeps injecting $120BN in liquidity every month.

“If the pandemic persists for longer than anticipated — especially if there are extended delays in the production or distribution of a successful vaccine — downward pressure on the U.S. economy could derail the nascent recovery and strain financial markets,” the report said. “Given the generally high level of leverage in the non-financial business sector, prolonged weak profits could trigger financial stress and defaults.”

And while there is much more in the full report (embedded below and linked here), including a lot of pretty charts one thing to note is that for the first time ever, the Fed included a section discussing the “implications of climate change for financial stability.” In other words, it’s not the Fed’s fault there is a massive bubble: blame the weather.

One final point: in perhaps the most ominous note in the report, the Fed warned that its own tools may soon be useless:

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Author: Tyler Durden

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