The Fed's Balance of Risks?

Tae Kim of CNBC reports, The Federal Reserve thinks stocks and commercial real estate prices are getting too rich:

Federal Reserve policymakers believe financial market asset prices are high, according to the central bank's "Monetary Policy Report" to Congress on Friday.

"Valuation pressures continue to be elevated across a range of asset classes, including equities and commercial real estate," the report said. "Over the second half of 2017, valuation pressures edged up from already elevated levels. In general, valuations are higher than would be expected based solely on the current level of longer-term Treasury yields."

The Fed noted the price-earnings ratios for U.S. stocks were "close to their highest levels outside of the 1990s."

The central bank's "elevated" valuation comments are noteworthy given the market has sold off since late January. The S&P 500 has declined 4 percent in February through Thursday.

The Fed also is not too concerned yet over the levels of debt in the banking sector.

"Overall vulnerabilities in the U.S. financial system remain moderate on balance," the report said. "Vulnerabilities from leverage in the financial sector appear low, reflecting in part capital and liquidity ratios of banks that have continued to improve from already strong positions."

You can read the Fed's latest Monetary Policy Report here. I note the following on financial stability:

Vulnerabilities in the U.S. financial system are judged to be moderate on balance. Valuation pressures continue to be elevated across a range of asset classes even after taking into account the current level of Treasury yields and the expectation that the reduction in corporate tax rates should generate an increase in after-tax earnings. Leverage in the nonfinancial business sector has remained high, and net issuance of risky debt has climbed in recent months. In contrast, leverage in the household sector has remained at a relatively low level, and household debt in recent years has expanded only about in line with nominal income. Moreover, U.S. banks are well capitalized and have significant liquidity buffers.

I'm very surprised the Fed feels household debt isn't a problem when you read comments on how debt is on track to destroy the American middle class, but apparently Americans are getting better at saving.

As far as risks to the banking and financial system, here too I would caution readers to take these findings with a grain of salt. There are risks and there is a lot of leverage in the system. It also doesn't help when pensions start taking stupid risks like shorting volatility at will to achieve their return target.

[Note: Read Karl Gauvin's LinkedIn comment, The Truth About Short VIX Strategies.]

What else caught my attention in the Fed's Monetary Policy Report? This little tidbit on global inflation:

Inflation has generally come in below central banks' targets in the advanced economies for several years now. Resource slack and commodity prices--as well as, for the United States, movements in the U.S. dollar--appear to explain inflation's behavior fairly well. But our understanding is imperfect, and other, possibly more persistent, factors may be at work. Resource slack at home and abroad might be greater than it appears to be, or inflation expectations could be lower than suggested by the available indicators. Moreover, some observers have pointed to increased competition from online retailers or international developments--such as global economic slack or the integration of emerging economies into the world economy--as contributing to lower inflation. Policymakers remain attentive to the possibility of such forces leading to continued low inflation; they also are watchful regarding the opposite risk of inflation moving undesirably high. (See the box "Low Inflation in the Advanced Economies" in Part 1.)

I still feel that structural deflation forces are going to swamp the global economy and keep rates ultra-low for many more years.

Anyway, take the time to read the Fed's latest Monetary Policy Report here, it's well worth reading it very carefully as it's well written.

The Fed also addressed fears that shrinking its balance sheet will impact the economy. Greg Robb of MarketWatch reports, Good news — the Fed’s shift to quantitative tightening might not be as painful as expected:

A new study of Federal Reserve policy released Friday has questioned the conventional wisdom that long-term Treasury yields will rise by about 100 basis points due to the Federal Reserve’s plan to shrink its balance sheet.

The new study, released at a prestigious gathering of senior Fed officials and Wall Street economists in New York, says the exit from the unconventional monetary policy may not be as “painful” as expected.

“Our overall conclusion is that the size of the Fed’s balance sheet is less potent in moving the bond market than as perceived by many,” the experts said.

That’s good news for the economy. There has been a lingering fear that the Fed’s asset purchases had kept rates artificially low and that they might snap higher once the Fed started to shrink its $4.5 trillion balance sheet.

There was worry that bondholders would stampede toward the exit at the same time, similar to the “taper tantrum” of 2013, when the Fed signaled plans to reduce its economy-boosting bond buying and triggered a jump in market yields that well preceded any actual Fed move.

The paper was written by David Greenlaw, senior fixed income economist for Morgan Stanley, Ethan Harris, head of global economics at Bank of America Merrill Lynch, and two top academic economists, Kenneth West of the University of Wisconsin and James Hamilton of the University of California at San Diego. It was presented Friday at the U.S. Monetary Policy Forum sponsored by the University of Chicago Booth School of Business.

Last fall, the Fed announced plans to slowly reduce its balance sheet on auto-pilot, allowing holdings to shrink by $20 billion each month this quarter and moving up to a maximum of $50 billion per month by the end of the year.

So far, the paper noted, the Fed’s initial exit signals have had relatively little impact on the market, which have amounted to a “collective shrug.”

The flip side of this argument is that should the Fed have to flip the switch and use an asset purchase program again, it might not be strong enough to push Treasury yields, and borrowing costs, lower during the next recession.

This means the Fed will need some new ammunition to fight the next downturn. In the past, the central bank has typically slashed interest rates by 4% to spur growth during a downturn, but its target for short-term rates is now only between 1.25%-1.5%.

The Fed has not announced how low it wants to shrink its balance sheet. New Fed Chairman Jerome Powell discussed a target range of $2.5 trillion to $2.9 trillion in his confirmation hearing last fall.

The analysts behind the paper called on the central bank to announce a size soon. They said it was unlikely that the Fed would be able to shrink the balance sheet below $3 trillion without changing how it sets interest rates.

The experts make some policy recommendations:

• The Fed should make a determination of the appropriate size of the Fed’s balance sheet over the long term and provide market guidance as soon as possible.
• The Fed should preserve the right to buy mortgage-backed securities given the likely low policy ammunition around the next crisis.
• The Fed should return to a balance sheet that consists mostly of short-term Treasury securities.
• The central bank should consider larger and looser caps on rolling off securities, perhaps removing them completely by 2019.

All this talk about the Fed shrinking its balance sheet and its impact on the economy is much ado about nothing.

In fact, if my prediction that the US economy will slow significantly in the second half of the year comes true, I wouldn't be surprised if the Fed pauses its balance sheet reduction or signals a pause.

It all depends on how bad things get. Bridgewater's Ray Dalio sees 70 percent chance of recession before 2020 but doesn't see a bubble yet:

Billionaire investor Ray Dalio, who founded world’s largest hedge fund Bridgewater Associates, thinks there is a relatively high chance the U.S. economy will stumble into a recession before the next presidential election in 2020.

Dalio said the U.S. economy is not currently in a bubble. But he reasoned that it might not take long to get there and then to move on to a “bust” phase.

”I think we are in a pre-bubble stage that could go into a bubble stage ... The probability of a recession prior to the next presidential election would be relatively high, maybe 70 percent, Dalio said during an appearance at the Harvard Kennedy School’s Institute of Politics.

Dalio, whose fund invests some $160 billion, stepped down from the hedge fund’s day-to-day operations nearly a year ago, but his views on markets and the economy are still very closely followed.

At the event, Lawrence Summers, a former Treasury secretary and former Harvard president, asked Dalio questions including what advice he would give individual investors who may have been rattled by the market’s recent turbulence after years of steady gains.

Dalio said investors should not panic and need to have a sound plan. If people become scared after the market has tumbled, it is too late, Dalio said, adding that people should probably buy when they are frightened and sell when they are not.

“The greatest mistake of the individual investor is to think that a market that did well is a good market rather than a more expensive market,” he said.

Dalio refused to discuss the firm’s portfolio and said that many of Bridgewater’s moves could be easily misinterpreted, including recent short bets against a number of European companies. “Don’t read anything into that. You’ll probably be misled.”

Dalio's advice is sound and indeed, the last correction proved to be short-lived, but what if we get a nasty bear market that lasts three or more years? We haven't had a prolonged bear market in a long time, and we're due for one. It doesn't mean it will happen for sure but investors need to prepare for it.

On that note, take the time to read my last comment on the bond teddy bear market and learn why US bonds are still very important to diversify risk and help protect against major downside risks inherent in risk assets.

Below, CNBC's Dominic Chu looks ahead to what are likely to be next week's top business and financial stories. And Jeffrey Gundlach, DoubleLine Capital CEO, discusses his views on the bond market and US nominal GDP.

Lastly, I embedded a discussion between Lawrence Summers, a former Treasury secretary and former Harvard president, and Ray Dalio at the Harvard Kennedy School’s Institute of Politics. Take the time to watch this, great discussion.