May 8, 2019
Federal Reserve's junk bond warning crashes world markets
The Federal Reserve crashed world stock and bond markets by issuing a report that record levels of junk loans represent a major U.S. economic risk.
The Fed’s latest semi-annual ‘Financial Stability Report’ revealed that risky loans issued to highly leveraged individuals and companies rose by 20 percent in 2018 to $1.15 trillion, and now exceed their peak levels reached previously in 2007. The warning sent the Dow Jones Industrial Stock Average down by 650 points, before a slight recovery.
The Federal Reserve is now mandated by the U.S. Congress to maintain monetary and financial stability in the flow of credit to the U.S. economy, while promoting its dual objectives regarding full employment and stable prices. To limit potential adverse events, like the 2007-2009 financial crisis, the Financial Stability Oversight Council chaired by the Secretary of the Treasury Steven Mnuchin, Federal Reserve Board Chair Jerome Powell and other financial regulators issued its latest report on May 6.
The FSR disclosed that outstanding high-quality U.S. financial assets have been growing at or below their long-term trend over the last decade. But leveraged loans jumped by 20.1% last year and grew by an average of 15.8% over the last decade.
The Federal Reserve drove interest rates down during the Obama administration to super-stimulate the economy by increasing its holdings of financial assets from about $872 billion to $4.5 trillion.
But to supposedly slow down financial speculation, the Fed hiked interest rate 4 times in 2018 and shrank its balance sheet by $600 billion.
President Trump has repeatedly criticized the Fed for tightening the supply of credit that has raised interest rates, despite the “headline personal consumption expenditures” rate of inflation running below the Fed’s own 2% annual target.
President of the Dallas Federal Reserve Bank Robert Kaplan tried to calm world market jitters about speculative lending in a May 7 speech at the Stanford’s Hoover Institution. Kaplan stated that Dallas Fed economists expect GDP growth to slow from a booming 3.2% growth in the first quarter to a moderate 2.25% for the full year.
But former Senate Banking Committee Chairman Phil Gramm has argued earlier this year that due to the Fed’s “monetary excesses,” that included ballooning its balance to overstimulate the economy during Obama’s eight years, it now “has less ability to control interest rates than it has had in its entire 105-year history.”
Gramm has warned that big North American “private equity” pools have raised about $448 billion. These institutional investors have very limited Federal Reserve lending oversight and can leverage their equity by as much as six times to almost $3 trillion.
The latest ‘Financial Stability Report’ states that liquidity risks associated with mismatched deposit to loan maturities for the $14 trillion U.S. banking sector “remain low” and only increased at the same pace as GDP growth with inflation last year.
But the FSR also stated that the interest rate premium spread over U.S. Treasury bonds for newly issued below investment grade (“junk”) leveraged loans almost doubled late last year to 5.25% and is still elevated at about a 4% premium. The FSR adds that although defaults on these loans remain low, “Companies with large amounts of debt are borrowing more money at a breakneck pace.”
With markets around the world crashing in sympathy with today’s rout on Wall Street, CNBC broadcast a midday interview with DoubleLine Capital managing partner Jeff Gundlach, who has been warning about junk loan risk. Gundlach stated that he thinks the 50% risk that President Trump doubles down on the trade war raising tariffs on Chinese imports could be a tipping point for stocks to “power lower.”
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