Who to Blame for the Flattening Yield Curve

From Moody’s

The U.S. economy is humming along, but we believe that the economy will weaken and likely fall into recession sometime in 2020 as the boost from the fiscal stimulus fades. There is considerable uncertainty in the timing of the next recession, but the U.S. bond market increases our concerns about the economy in the next couple of years.

Since the mid-1960s, the yield curve, or the difference between the 10-year Treasury yield and threemonth yield, has been nearly perfect in predicting recessions. On average a recession occurs 15 months after the yield curve inverts. The shortest time between an inversion and a recession was eight months in the early 1970s. The longest was 20 months in the late 1960s. It has given only one false signal, in 1966, when a slowdown—but not an official recession—followed an inversion.

Assuming our forecast for the next downturn is correct, the yield curve should invert late this year or early next. Further flattening in the yield curve doesn’t alter our forecast for GDP growth this year, but it does pose some downside risk. As the yield curve flattens, it could weigh on the collective psyche, particularly among investors. Investors are a fickle bunch, and the further flattening in the yield curve could increase the odds of a sudden decline in stock prices, which if significant and persistent could have noticeable economic costs.

Knowing why the yield curve is flattening is important in assessing whether there should be concern about growth this year and early next. If it is because the lower long-term rates are fueled by concerns about U.S. growth, that would raise a red flag. This doesn’t appear to be the case now, because the 10-year U.S. Treasury yield has been hovering generally between 2.8% and 2.9% since the beginning of February and is up 40 basis points since the end of 2017. Therefore, the flattening in the yield curve is coming from the short end, which has put the focus on the Fed. But the central bank is only part of the story.

The flattening in the yield curve is less troubling for the economy in the very short run if it’s occurring because the economy is doing well and the Fed is raising short-term rates while the long-term rate continues to be depressed by the size of the Fed’s and other global central banks’ balance sheets.

It doesn’t appear that the dynamics for long-term rates will change significantly soon, so the next rate hike by the Fed, likely in June, will flatten the yield curve further. Therefore, the Fed will feel the heat for
flattening the yield curve, potentially fanning concerns that it is headed for a policy mistake that will end this expansion.

However, the Fed isn’t the only reason that the yield curve is flattening. The Treasury Department has ramped up its issuance in anticipation of a higher deficit from last year’s tax overhaul and a two-year budget deal that will increase federal spending over the next two years. Over the past few months, Treasury net issuance of bills has spiked. Net issuance of bills in March was $211 billion following a net $111 billion in February. The increase in supply has driven short-term interest rates higher. In fact, prior to the Fed rate hike in March, the spread between the three-month Treasury bill and the fed funds rate was the widest over the past 15 years.

We see the odds rising that the yield curve inverts by the end of this year. This would increase the odds of a recession in the subsequent 12 months.

Elevated US Leverage and Rate Rises

Markets are beginning to ask whether companies will be capable of passing on higher costs to the U.S.’ less than financially robust middle class, according to Moodys.

The U.S.’ still relatively low personal savings rate questions how easily consumers will absorb recent and any forthcoming price hikes. Moreover, the recent slide by Moody’s industrial metals price index amid dollar exchange rate weakness hints of a leveling off of global business activity.

Missing from last week’s discussion of a record ratio of U.S. nonfinancial-corporate debt to GDP was any mention of 2017’s near-record high ratio of total U.S. private and public nonfinancial-sector debt relative to GDP. The yearlong averages of 2017 showed $49.05 trillion of total nonfinancial-sector debt and $19.74 trillion of nominal GDP that put nonfinancial-sector debt at 249% of GDP—or just a tad under 2016’s record 250%.

The leveraging up of the U.S. economy has coincided with a downshifting of U.S. economic growth. From 1961 through 1979, U.S. real GDP expanded by an astounding 3.9% annually, on average, while total nonfinancial-sector debt approximated 133% of nominal GDP. When real GDP’s average annual rate of growth eased to the 3.2% of 1979-2000, the ratio of nonfinancial-sector debt to GDP rose to 176%. Since the end of 2000, U.S. economic growth has averaged only 1.8% annually and, in a possible response to subpar growth, nonfinancial-sector debt has soared to 232% of GDP

High Systemic Leverage Reins in Benchmark Yields

Over time, the record shows that the climb by the moving 10-year ratio of nonfinancial-sector debt to GDP has been accompanied by a declining 10-year moving average for the 10-year Treasury yield. For example, as the moving 10-year ratio of debt to GDP rose from 1997’s 183% to 2017’s 245%, the 10-year Treasury yield’s moving 10-year average fell from 7.31% to 2.59%.

Two factors may be at work. First, lower interest rates encourage an increase in balance-sheet leverage. Second, to the degree an elevated ratio of debt to GDP heightens the economy’s sensitivity to an increase in interest rates, lofty readings for leverage limit the upside for interest rates. Moreover, as shown by the historical record, if higher leverage tends to occur amid a slower underlying pace of economic growth, then the case favoring relatively low interest rates amid high leverage is strengthened.

None of this dismisses the possibility of an extended stay above 3% by the 10-year Treasury yield. Instead, today’s record ratio of debt to GDP warns of greater downside risk for business activity whenever interest rates enter into a protracted climb.

NSW Property Prices To “Correct” ~10% – Moody’s

As reported in the Business Insider, Moody’s Investor Services thinks there will be further declines to come, suggesting that Sydney prices will suffer a “correction” in the year ahead.

“Incomes in NSW have increased faster than the national average and underpin some of the recent gains in home values,” Moody’s says, pointing to the chart below. “However, housing values have risen even faster and are overvalued relative to equilibrium value. Therefore, Moody’s Analytics expects a correction across NSW.”

Higher asset threshold for US SIFI designation will ease some banks’ regulatory oversight, a credit negative

From Moody’s

Last Wednesday, the US Senate passed the Economic Growth, Regulatory Relief, and Consumer Protection Act. A key component of this bill increases the asset threshold for a bank to be designated a systemically important financial institution (SIFI) to $250 billion of total consolidated assets from $50 billion, the threshold defined in the Dodd-Frank Act of 2010.

For US banks with assets of less than $250 billion, the higher asset threshold for SIFI designation is likely to lead to a relaxation of risk governance and encourage more aggressive capital management, a credit-negative outcome.

SIFI banks are subject to the enhanced prudential standards of the US Federal Reserve (Fed). The regulatory oversight of SIFIs is greater than for other banks, and SIFIs participate in the Fed’s annual Dodd-Frank Act stress test (DFAST) and the Comprehensive Capital Analysis and Review (CCAR), which evaluate banks’ capital adequacy under stress scenarios. Furthermore, transparency will decline with fewer participants in the public comparative assessment the stress tests provide.

In 2018, the 38 bank holding companies shown in the exhibit below are subject to the Fed’s annual capital stress test. Passage of the bill into law would immediately exempt four banks with less than $100 billion of assets from the Fed’s enhanced prudential standards, which includes the stress test and living will requirements. These banks will have the most leeway in relaxing risk governance practices and managing their capital.

The 21 banks at the right of the top exhibit that have assets of $100-$250 billion1 could become exempt from enhanced prudential standards 18 months after passage of the bill into law. However, the Fed will have the authority to apply enhanced oversight to any bank holding company of this asset size and will still conduct periodic stress tests. In the 18 months after passage into law, it will be up to the Fed to develop a more tailored enhanced oversight regime for the $100-$250 billion asset group. The Fed also could continue to apply the same enhanced prudential standards. Therefore, it is difficult to assess the potential for their easier risk governance practices until more about the regulatory oversight is known.

If many of these banks are no longer required to participate in the public stress tests, it would reduce transparency. The quantitative results of DFAST and CCAR provide a relative rank ordering of stress capital resilience under a common set of assumptions. The loss of such transparency is credit negative.

For the largest banks, those with more than $250 billion in assets that remain SIFIs, there are no changes in the Fed’s supervision. The bill also specifies that foreign banking organizations with consolidated assets of $100 billion or more are still subject to enhanced prudential standards and intermediate holding company requirements.

In order to become law, the bill must also be passed by the US House of Representatives and signed by the president. This year’s annual Fed stress test will proceed as usual with submissions by the banks due 5 April, with results announced in June.


Norwegian parliament’s debate of Bank Recovery and Resolution Directive is credit negative for banks

From Moody’s.

Last Tuesday, Norway’s parliament began debating proposed legislation to implement the Bank Recovery and Resolution Directive (BRRD) and an amended deposit guarantee scheme.

The intention of the BRRD law is to promote financial stability and ensure that losses are borne by a bank’s shareholders and creditors rather thantaxpayers. Although the first reading in parliament concluded with a unanimous vote in favour for the proposal, a second reading (at least three days after the initial reading) is required before the bill can be transposed into Norwegian law. The BRRD law’s enactment, which we expect within the next few weeks, would be credit negative for seven of the 17 Norwegian banks we rate because it would reduce the probability that they would receive government support in case of need.

In line with the European Union’s (EU) BRRD, the proposed legal framework features recovery and resolution plans for banks, early intervention measures and resolution tools including the bail-in of creditors. Additionally, the proposal includes small changes to the current deposit guarantee scheme to align it with that of the EU. However, in contrast to the EU’s deposit guarantee scheme limit of €100,000 per depositor per bank, the Norwegian Ministry of Finance has proposed maintaining its current coverage of NOK2 million (approximately €200,000) per depositor in each bank.

The bail-in tool is a central feature in the BRRD framework, intended to reduce the need for government intervention in failing banks. Consequently, government support is less likely for Norwegian banks since bail-in can be used to recapitalise financial institutions and absorb losses.

We assigned negative outlooks to those banks’ ratings following the submission of the legislative proposal in June 2017 in anticipation of the law’s passage, and the eventual moderation of our government support assumptions, which likely will lead us to remove the one-notch rating uplift incorporated into the banks’ ratings.

We expect Norway’s implementation of BRRD to be followed by a minimum requirement for own funds and liabilities (MREL) for each bank within the next 12 months. Nevertheless, no relevant details have been disclosed yet, although the BRRD proposal includes MREL requirements in line with the EU’s BRRD.

We expect Norwegian banks that will be subject to MREL requirements to gradually change their funding plans by raising non-preferred senior debt instruments in order to be compliant. This likely will provide senior unsecured creditors additional protection against potential losses, which eventually could counterbalance the negative rating effect on banks from revised government support assumptions.

Wealth Management A Risk To Wells Fargo

Wells Fargo’s review of its wealth management business threatens to broaden its reputational damage, according to Moody’s.

Last Thursday, Wells Fargo & Company filed its annual 10-K report with the US Securities and Exchange Commission. The report disclosed the existence of an ongoing review by Wells Fargo’s board of directors into potentially inappropriate referrals or recommendations at its Wealth and Investment Management (WIM) business, as well as a separate company review of fee calculations within WIM that resulted in overcharges for some customers. The existence of these reviews is credit negative.

Before last week’s disclosures, Wells Fargo’s inappropriate sales practices centered on its large retail banking operations. Since September 2016, when Wells Fargo first announced regulatory settlements related to retail banking sales misconduct, the bank has also disclosed issues in its auto lending business and in its assessment of fees for mortgage rate-lock extensions. These disclosures have resulted in significant reputational damage.

Consequently, we believe Wells Fargo’s reputation would suffer further if inappropriate practices were found in its nationwide WIM business.

Wells Fargo has made rebuilding trust its top priority, and over the past year and a half has taken numerous credit-positive steps to strengthen its governance and risk oversight. However, the widespread nature of Wells Fargo’s wrongdoing also resulted in a broadly publicized consent order with the US Federal Reserve that restricts the bank from growing its balance sheet beyond its year-end 2017 size and calls for more enhancements to its governance and risk management.

These circumstances, and the heightened scrutiny that Wells Fargo faces, magnify each additional revelation of inappropriate practices. Therefore, although the newly disclosed reviews into Wells Fargo’s WIM business are in their preliminary stages, we believe they undermine the bank’s effort to rebuild trust.

Moreover, the board’s review into whether there have been inappropriate referrals or recommendations affecting WIM’s brokerage and other customers was initiated in response to inquiries from US government agencies, raising the possibility of another regulatory sanction at the conclusion of the review. Similarly, Wells Fargo’s filing highlighted a separate internal review of policies, practices and procedures in its foreign-exchange business that is also a response to inquiries from government agencies.

Wells Fargo’s 10-K also included a report from its auditor, KPMG, in which KPMG expressed an unqualified opinion on Wells Fargo’s financial statements and an unqualified opinion on the effectiveness of its internal controls over financial reporting. This is positive because it indicates that Wells Fargo’s auditors do not believe the bank’s aggressive sales practices compromised its financial reporting in any material respect.

Norway Tightens Mortgage Regulation

Norway, one of the countries mirroring the Australian mortgage debt bubble (223%) has taken steps to tighten mortgage lending further. This includes a limit of 5x gross annual income and a 5% interest rate buffer.

According to Moody’s, last Wednesday, the Norwegian Financial Services Authority (FSA) proposed to the Ministry of Finance a new regulation on requirements for residential loans. The proposed national regulation is based on existing and Oslo-specific policy measures introduced in January 2017 and scheduled to expire 30 June 2018 that cap the portion of a mortgage that does not comply with the national applicable loan-to-value (LTV) ratio limit at 8% from 10% previously. Extending these measures past their scheduled expiration will contain borrower leverage, a structural risk for Norway’s banking sector, and dampen house price inflation, both credit positive.

The proposal maintains the maximum LTV for home equity credit lines at 60%, continues to cap the LTV on mortgages at 85%, and leaves unchanged the limit on borrowers’ aggregate debt at 5x gross annual income. However, the FSA suggests eliminating the existing LTV limit of 60% for secondary homes located in Oslo (see exhibit).

Household debt reached a record 223% of disposable income in June 2017, far above that of other Nordic countries, and we expect it to remain close to current levels over the next 12-18 months. This trend remains a structural risk for Norway’s banking sector.

Although the Ministry of Finance will make the final decision on whether to accept the recommendation and in what form, the proposal is a step to improve mortgage underwriting standards by containing borrower leverage. Norwegian banks are retail focused, with mortgages accounting for almost 50% of their total lending. The proposed expansion of the previously Oslo-specific measures will improve banks’ asset quality and increase mortgage competition in Oslo. Smaller regional banks will be able to compete for mortgages in Oslo with DNB Bank ASA (Aa2/Aa2 negative, a34), which has the largest share of Oslo’s retail market, because they will be able to account for deviations from the suggested LTV limits against their entire loan book rather than the small share of Oslo-originated loans in accordance with current regulation.

House prices in Norway have declined 4.2% since peaking in March 2017. The decline followed the Ministry of Finance’s 2017 implementation of tighter mortgage lending criteria in response to accelerating property price inflation and rising household indebtedness. The restrictions have cut demand for investment properties in large city centres, particularly the Oslo metropolitan area, where house prices have grown fastest in recent years.

US Debt Will Grow, But It’s Mostly Government Borrowing

Moody’s says a possible $975 billion increase in U.S. government debt for fiscal 2018 would leave Q3-2018’s outstanding federal debt up by 5.9% annually. As of Q3-2017, federal debt outstanding grew by $597
billion, or 3.8%, from a year earlier.

Into the indefinite future, federal debt is likely to materially outrun each of the other broad components of U.S. nonfinancial-sector debt. Because of non-federal debt’s relatively slow growth, the private and public debt of the U.S.’ nonfinancial sectors may grow no faster than 4.3% annually during the year ended Q3-2018 to a record $50.77 trillion. For the year-ended Q3-2017, this most comprehensive estimate of U.S. nonfinancial-sector debt rose by 3.8% to $48.64 trillion.

Though expectations of faster growth for total nonfinancial-sector debt complements forecasts of higher short- and long-term interest rates for 2018, the quickening of total nonfinancial-sector debt growth may not be enough to sustain the 10-year Treasury yield above the 2.85% average that the Blue Chip consensus recently predicted for 2018.

The projected growth of nonfinancial-sector debt looks manageable from a historical perspective. For one thing, 2018’s projected percent increase by debt lags far behind the 9.1% average annual advance by U.S. nonfinancial sector debt from the five-years-ended 2007. Back then, unsustainably rapid growth for total nonfinancial-sector debt and 2003-2007’s 2.1% annualized rate of core PCE price index inflation supplied a 4.4% average for the 10-year Treasury yield of the five-years-ended 2007. By contrast, the 10-year Treasury yield’s moving five-year average sagged to 2.2% during the span-ended September 2017 as the accompanying five-year average annualized growth rates descended to 4.4% for nonfinancial-sector debt and 1.5% for core PCE price index inflation.

Moody’s On APRA’s Credit Reforms

Last Wednesday, the Australian Prudential Regulation Authority (APRA) proposed key revisions to its capital framework for authorized deposit taking institutions (ADIs). The revisions cover the calculation of credit,
market and operational risks. These proposed changes are credit positive for Australian ADIs because they will improve the alignment of capital and asset risks in their loan portfolios. Moody’s says the key proposals are as follows:

  • Revisions to the capital treatment of residential mortgage portfolios under the standardized and advanced approaches, with higher capital requirements for higher-risk segments
  • Amendments to the treatment of other exposures to improve the risk sensitivity of risk-weighted asset outcomes by including both additional granularity and recalibrating existing risk weights and credit
    conversion factors for some portfolios
  • Additional constraints on the use of ADIs’ own risk parameter estimates under internal ratings-based approaches to determine capital requirements for credit risks and introducing an overall floor to riskweighted assets for ADIs using the standardized approach
  • Introduction of a single replacement methodology for the current advanced and standardized approaches to operational risks
  • Introduction of a simpler approach for small, less complex ADIs to reduce the regulatory burden without compromising prudential soundness

A particularly significant element of the new regime is a reform of the capital treatment of residential mortgages, given that more than 60% of Australian banks’ total loans were residential mortgages as of January 2018.

The improved alignment of capital to risk for residential mortgages will come from hikes in risk weights on several higher-risk loan segments. APRA proposes increased risk weights for mortgages used for investment purposes, those with interest-only features and those with higher loan-to-valuation ratios (LVR). At the same time, risk weights for some lower-risk segments likely will drop. For example, under the standardized approach, standard mortgages with LVR ratios lower than 80% will require risk weights of only 20%-30%, down from 35% under current requirements.

The higher capital charges on investment loans will better reflect their higher sensitivity to economic cycles. During periods of economic strength investment loans perform well. As Exhibit 1 shows, on a national basis
and during a time of strong economic growth, defaults on investment loans have been lower than owner occupier loans.

However, in Western Australia, where the economy has deteriorated following the end of the investment boom in resources, defaults on investment loans have been higher than owner-occupier loans, as Exhibit 2 shows.

Investment loans also are sensitive to the interest rate cycle. During periods of rising interest rates, investment loans tend to experience higher default rates than owner-occupier loans, as shown in Exhibit 3.

Corporate Bonds Beg to Differ with Their Equity Brethren

From Moody’s

Thus far, the corporate credit market has been relatively steady amid equity market turmoil. Corporate credit’s comparative calm stems from expectations of continued profit growth that underpins a still likely slide by the high-yield default rate. The record shows that 90% of the year-to-year declines by the default rate were joined by year-to-year growth for the market value of U.S. common stock.

Today’s positive outlooks for business sales and operating profits suggest that equities will recover once issues pertaining to interest rates are sufficiently resolved. For now, equities may be paying dearly for having been more richly priced vis-a-vis fundamentals when compared to corporate bonds.

Since the VIX index’s current estimation methodology took effect in September 2003, the high-yield bond spread has generated a strong correlation of 0.90 with the VIX index. However, for now that ordinarily tight relationship has broken down. Never before has the high-yield bond spread been so unresponsive to a skyrocketing VIX index.

The VIX index’s 28.5-point average of February-to-date has been statistically associated with an 832-basis-point midpoint for the high-yield bond spread. Instead, the high-yield bond spread recently approximated 353 bp. Thus, the high-yield spread predicted by the VIX index now exceeds the actual spread by a record 479 bp.

The old record high gap was the 364 bp of October 2008, or when the actual spread of 1,398 bp would eventually surpass the 1,762 bp predicted by the VIX index. Not long thereafter, the actual high-yield spread would peak at the 1,932 bp of December 2008.

More recently, or during the euro zone crisis of 2011, the 1,018 bp high-yield spread predicted by the VIX index was as much as 323 bp above August 2011’s actual spread of 695 bp. After eventually peaking at October 2011’s 775 bp, the spread narrowed to 590 bp by August 2012.

What transpired following August 2011 and October 2008 warns against being too quick to dismiss the possibility of at least a 100 bp widening by the latest high-yield spread. Nevertheless, high-yield spreads would be significantly thinner one year after the gap between the predicted and actual spreads peaked.

For example, by August 2012, the high-yield spread had narrowed to 590 bp, while the spread had thinned to 737 bp by October 2009.