Two Risks to Stability Are Building Amid Short-Term Calm

(Bloomberg Opinion) -- The Federal Reserve, in its most recent semiannual report about risks to financial stability, concluded that there are no serious immediate threats. So does this mean we should relax? I definitely don’t think so. In my view, not only are two significant risks on the horizon, but both seem likely to be realized in the years ahead. 

As for short-term risks, the Fed’s report, released on Friday, concluded in particular:

• Although asset prices remain high in several markets, this is mostly because Treasury yields are low. When analyzed relative to the level of Treasury yields, valuations in the corporate bond and equity market are close to their historical norms. 
• Business borrowing is high, but household borrowing “remains at a modest level relative to income.”
• Leverage in the financial sector is low.
• Funding risk remains modest. 
• The level of vulnerabilities has changed little since the previous report in May.

Within that report, though, are the seeds of the two longer-term risks I mentioned.

The first is that low Treasury bond yields are not sustainable. That’s a critical risk because the valuation of other important U.S. financial markets, including the corporate bond and equity markets, depend on the low level of Treasury yields.

As I see it, the potential for a significant rise in long-dated Treasury yields is high. First, the starting point is one of unusually low yields, especially at this stage of the business cycle, with 10-year Treasury yields at about 1.8%. Yields are extraordinarily low because real yields — those adjusted for inflation — are depressed. For example, the short-term interest rate judged as consistent with a neutral monetary policy is now around zero, about 200 basis points lower than its historical level. Also, yields are low because bond term premia — the long-run average spread between long-term Treasury yields and short-term rates — are in negative territory. In contrast, before this business cycle, the historical spread between 10-year Treasury yields and three-month rates was about 100 basis points.

Second, there are good reasons to expect that bond term premia will rise over time. Bond term premia are unusually low because investors are more worried about the risk of recession than the risk of higher inflation. Bonds are viewed as a hedge to other riskier assets that investors hold in their portfolios such as corporate debt and equities. 

But the low bond term premia are unlikely to persist much longer. The Fed’s actions have reduced the risk of recession and increased the risk of higher inflation. Yet this has barely been priced into bond market valuations. 

Moreover, term premia should rise over time as chronic budget deficits require large increases in the supply of Treasury debt. Not only does the Congressional Budget Office project large deficits as far as the eye can see, but as bond yields rise, debt-service costs will increase, leading to bigger budget deficits and even more supply.

The second long-term risk is the buildup of corporate debt — especially in the BBB rated and high-yield areas. In recent years, U.S. corporations have taken advantage of low interest rates and narrow corporate credit spreads to increase their leverage and move down the credit-quality curve. For many chief executive officers, the calculus has been simple — more leverage facilitates greater share buybacks. That shrinks the number of shares outstanding, boosting earnings per share and the company’s stock price. 

This is all incredibly pleasant during a period of sustained economic expansion. But as Ed McKelvey and I wrote two decades ago, there is a dark side to the brave (i.e., longer) business cycle. When recessions become less frequent, the shock of recession becomes greater when they do ultimately occur; this leads, inevitably, to greater turmoil in financial markets. Recent recessions, such as the 2000-01 bursting of the technology stock bubble or the 2007-09 financial crisis, have a greater financial instability component compared with earlier economic downturns. 

This pattern is unlikely to be broken next time. After all, the growth in corporate debt has been concentrated in the BBB rated sector. When the next recession occurs, a significant portion of this debt will be downgraded to junk. Credit spreads for this debt will rise because of the deterioration in quality. 

But the story isn’t likely to end there. Forced selling will generate significant congestion within the corporate debt market. After all, many investors with mandates that restrict holdings to investment-grade debt will have to unload their newly junk-rated bonds. This selling will push securities prices below their underlying value. Prices will have to become overly cheap to provoke opportunistic buying. 

Moreover, some of the changes made in the 2017 Tax Cuts and Jobs Act will increase the stress on highly leveraged companies. In particular, the law eliminated companies’ ability to offset losses during an economic downturn with refunds of federal corporate income taxes paid in earlier years. Also, the law limits the deductibility of interest relative to earnings before interest, tax, depreciation and amortization. As Ebitda falls in recession, those constraints will become more binding, further restricting the cash flow of highly leveraged companies. 

The increase in corporate debt leverage should not make a recession significantly more likely. However, when a recession does occur, the debt burden and the tax law will make the economic downturn worse. 

So enjoy the next year or two. As long as inflation stays low, the Fed will remain friendly, but this is unlikely to last. Pressures are already building on the financial stability front that will make the next economic downturn messier than anticipated.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.

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