Increased leverage in the nonfinancial sector, banks reaching for yield in a persistently low-interest rate environment and emerging markets pose a growing threat to the system, according to a report issued Tuesday by the Office of Financial Research.
The report said that so far the threats remain contained and do not pose a clear and present danger to the economy. But that could change quickly.
"Overall, threats to U.S. financial stability remain moderate … but they edged higher within that range over the past year," said OFR Director Richard Berner. "We see elevated and rising credit risks in U.S. nonfinancial business and in emerging‐market economies, the continued reach for yield in a climate of persistently low interest rates, and the uneven resilience of the financial system."
The report which is meant to supplement the OFR's annual report to Congress, which is due to be published in January found high levels of leverage, noting that the ratio of that debt to GDP has moved beyond pre-crisis highs. Credit markets have remained resilient, however, except for issuers of junk bonds and the energy and commodities industries, but the report says that resilience could be short-lived as creditors reconsider their exposure to those markets.
What is more, a combination of global economic factors could put U.S. market stability at risk in the face of another credit shock like the Chinese credit crisis experienced this past summer, the report found.
"The combination of higher corporate leverage, slower global growth and inflation, a stronger dollar, and the plunge in commodity prices is pressuring corporate earnings and weakening the debt-service capacity of many U.S. and emerging market borrowers," the report said. "A shock that significantly further impairs U.S. corporate or emerging market credit quality could potentially threaten U.S. financial stability."
The report said that the widely-held expectation that interest rates will remain low for years to come will mean that reach-for-yield behavior by investors will continue to expose the U.S. financial system to higher credit risks than might otherwise be the case.
It also said interest rate risk that is, the mismatch between the rates that a financial institution pays out and the returns it receives on its investments remains "historically high." That risk can be mitigated so long as the Federal Reserve is able to tighten monetary policy gradually and steadily, but if some prevailing factor say, unexpectedly rapid inflation growth were to force their hand, it could cause serious disturbance throughout the financial system.
"Several factors are keeping interest rates well below past norms," the report said. "If these factors changed suddenly, an interest rate shock or the inability of the Federal Reserve to normalize policy as desired could threaten financial stability."
The OFR report comes as the Federal Reserve is poised to consider raising its benchmark interest rates Dec. 16 for the first time in nine years. The prevailing viewpoint is that the Fed will raise rates between 25 and 50 basis points and will make incremental increases over the next few years, ultimately settling on an interest rate in the 3-4% range.