The latest Federal Reserve Financial Stability Report underestimates supply chain risks
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The Financial Times, Bloomberg, and The Wall Street Journal all give enough different views on the Fed’s latest Fed Financial Stability Report issued twice a year, so it seems useful to look at it. For your convenience, we embed it at the end of the post.
The entire document is worth looking at because it is likely to attract various benefits, such as post-mortem analysis of the March 2020 U.S. Treasury market turmoil, discussion of the risks of non-cash collateral from central counterparties, and memetic stocks. But the media is concerned Part is “Recent Risks in the Financial System”, starting on page 59.
Hope that ordinary readers have internalized the Fed’s framework:
- Elevated Valuation pressure Asset prices higher than economic fundamentals or historical standards are usually driven by investors’ increased willingness to take risks. Therefore, increased valuation pressure means that asset prices are more likely to fall sharply.
- Overmuch Lending for businesses and households If their income declines or the value of their assets declines, they can easily get into trouble.
- Overmuch Leverage in the financial sector Increasing the risk that financial institutions cannot absorb even meager losses…
- Capital risk Expose the financial system to the possibility of investors “running” by withdrawing funds…
I suspect that experts like Steve Keen and Richard Vague will be very frustrated by this. Usually, in academic work or even financial reports, the order of items indicates which are the most important. To see the central bank describe itself as focusing on asset price levels, what is worse, broadly speaking, this is frustrating.
Investors should be adults and know that they are taking risks as if they might suffer losses. Financial economics assumes that there is a risk-reward balance, that is, investors take more risks in order to obtain better results.
Therefore, the central bank should care about asset leverage, not asset prices themselves. Recall that we have a huge Internet bubble, but in public stocks, regulators have strict restrictions on margin loans. When it imploded, the financial system was not compromised. (Interestingly, some players managed to use their leverage to achieve fanaticism by substituting Internet stocks for cash… Just like McKinsey, it had to write off $200 million. It was due to The number of employees providing services to Internet companies panicking customers and providing services to customers who have eyeballs instead of cash has increased significantly, so the number of employees in North America has to be reduced by nearly 50% within two years).
But on the contrary, regardless of the extent of the rebound in financial institutions, the Fed regards itself as the guardian of asset prices because of the fairy of confidence. The continuation of the Greenspan-Bernanke-Yellen put option is responsible for these sharp declines in valuations, but you have never heard of how the Fed describes its observations that “oh, asset prices are quite high”.
Most experts who have carefully studied the crisis have found that high borrowing in the private sector, especially household borrowing, is the cause of the financial crisis.
Another risk factor for the financial crisis, strangely not appearing on the Fed’s list, is the high level of international capital flows. Ken Rogoff and Carmen Reinhart’s research on the 800-year financial crisis found that high levels of international capital flows are closely related to rising and growing financial crises. When their research came out, it received various praises. But no one is willing to take action on its obvious impact and start capital controls, or at least increase friction through transaction taxes. Time cannot be returned to the assumed progress of more globalization and financialization.
Let us now turn to the current list of worries. According to reports from the Financial Times and Bloomberg, this is China. Their headlines are: The Fed warns that the downturn in China’s real estate industry poses risks to the U.S. economy with As bond losses expand, China’s real estate pressure triggers Fed warning .
Although these titles are almost correct, they give the impression that the Fed lists China alone as an obvious and serious yellow danger to the health of the US economy. In fact, China ranks third. Here they are, in order:
The potential deterioration of the public health situation may lead to a decline in the confidence of enterprises and households, and have a negative impact on future economic activities and financial vulnerabilities…
The sharp rise in interest rates may slow down the pace of economic recovery, cause a sharp decline in asset valuations, and put pressure on financial institutions, businesses, and households…
The pressure of China’s real estate industry may put pressure on China’s financial system and may spread to the United States…
The unfavorable development of other emerging market economies triggered by the sudden and sharp tightening of financial conditions may also affect the United States…
In Europe, a slower-than-expected recovery due to strong transmission channels may trigger financial stress and pose a risk to the United States
In addition, if you read the part about China, you will feel that the Fed does not have a theory to explain how China’s rebound may occur, but China is too big, if it really becomes a pear shape, it may not affect the United States:
In China, corporate and local government debt is still large; the financial sector has high leverage, especially small and medium-sized banks; and real estate valuations have been pushed up. In this environment, the continued regulatory focus on leveraged institutions is likely to put pressure on some debt-laden companies, especially in the real estate industry. Recent concerns about China Evergrande Group are an example. In turn, pressure may spread to China’s financial system through spillover effects on financial companies, sudden adjustments in real estate prices, or a reduction in investor risk appetite. Given the scale of China’s economic and financial system and extensive trade links with other parts of the world, China’s financial pressures may put pressure on global financial markets through deteriorating risk sentiment, posing risks to global economic growth, and affecting the state of the United States.
Translation: The Fed has not seen any direct transmission mechanism from China’s financial system to us. However, the domestic financial crisis may lead to a sharp decline in trade. China’s suppliers’ accounts receivable payments have been slow, and many suppliers borrow money to make up for this. This contraction may affect other economies and their banks, and may spread to the United States, or more likely to directly hit confidence. Recall that China’s financial market has experienced several sharp declines, usually lasting only two weeks, and overseas markets have also fallen.
To be fair, one might argue that Bloomberg is using the Fed’s report to get an update on China’s deteriorating situation. From its article:
The shortage of cash is getting worse every day. The yield on the Bloomberg Index of Chinese Junk Dollar Bonds, dominated by real estate companies, has soared to 24%. Kaisa Group Holdings Co., Ltd. said last week that it had missed payments for wealth products and was further downgraded to junk by Fitch on Tuesday.
The sell-off has spread to higher-level issuers such as Country Garden Holdings Ltd., and even a company controlled by the Chinese government has seen its bonds plummet. On Tuesday, the spread between US investment grade bonds and US Treasury bonds widened to the largest since April.
So Bloomberg only discussed the Chinese part. “Financial Times” is headed by China, and six of the fourteen paragraphs specifically address it. Although the Fed does not classify them as “near-term risks”, but has a special section, three of them are memetic stocks. The article erroneously stated that the Fed’s warning to the country was only the sharp rise in interest rates and its impact on risky assets and housing. Did not mention any major items, Covid risks.
In contrast, the Wall Street Journal puts Covid first: The Fed says that the U.S. public health is the biggest risk facing the financial system in the near term The Wall Street Journal did not mention China, but emphasized that Fed officials are concerned about rising asset prices.
What’s striking is that the Fed’s report mentioned supply chain issues every time (the Wall Street Journal is commendably noting this). From the stability report:
The possible deterioration of public health conditions may slow the recent economic recovery, especially if widespread business closures and further disruptions to the supply chain.
Please note that the Central Bank believes that supply chain issues are not dangerous at the current level, nor are they a sufficient risk of harm to the economy without the resurgence of Covid.
However, there is no sign that the log blockage in West Coast ports has improved. Lambert quoted a Business Insider article yesterday in which a brave reporter took a boat to see what happened. The situation was no better than the previous boat ride, which described almost no action.
We have received reports that austerity may be about to become severe. As we reported in Links, rural hospitals on the flyover cannot get crutches or walkers due to aluminum shortages. It is easy to dismiss it as a function of the truck and train problem, but a reader said that a CEO of the industry said that the problem is not only widespread, but also serious, and it will be within two months. Inside becomes serious. Although aluminum is also recycled domestically, the equipment is picky and prone to breakdowns, and their supply of parts is very short. We also heard warnings about copper because of the high exit rate of recycling factories and mines, which rely on experienced personnel and it is difficult to recruit new employees. Operators attribute this to vax resistance; these people work in closed conditions with poor ventilation and know or believe they have been infected with the new crown virus and are unhappy with being asked to film. Claiming that they are now exiting, but the job market is strong.
Please note that these reports are anecdotal, except The story of a hospital shortage, Has not been independently confirmed. But this kind of story can easily fall through the cracks. The financial media is very empty, focusing on big markets and big industries. Domestic processors may be far below their radar. If this only causes buying panic, insiders don’t want to sound the alarm.
Therefore, please pay attention to supporting or contrary data points. If any of these shortages occur, it will be a very big problem.