Near-term risks to the financial system
As we look forward, developments in domestic and international markets could pose near-term risks to the financial system, with the ultimate effects likely depending on the vulnerabilities of the financial system identified earlier in this report. The Federal Reserve routinely engages with other domestic and international policymakers, academics, community groups, and others in part to gauge the set of risks of particular concern to these groups. The box "Salient Shocks to Financial Stability Cited in Market Outreach" presents the views from a range of financial market analysts. We review the possible interactions of existing vulnerabilities with three broad categories of potential risks identified in these conversations: stresses in Europe; risks emanating from emerging market economies (EMEs), including China; and an unexpected and marked slowing in U.S. economic growth.
Salient Shocks to Financial Stability Cited in Market Outreach
As part of its market intelligence gathering, Federal Reserve staff conduct outreach to a wide range of market and official-sector contacts to gather their views on risks to U.S. financial stability.1
Respondents to outreach during the first quarter of 2019 prominently cited spillovers from trade policy and shocks abroad—particularly from Europe and China—as well as risks emanating from a possible turn in the U.S. business and credit cycles. Of note, the episode of heightened market volatility toward the end of 2018 drew different interpretations across respondents; while some felt that the episode heightened downside growth risks, others characterized the selloff in risky assets as a beneficial correction that would attenuate vulnerabilities and prolong the current business cycle.
Risks from trade are the most cited, and slowing global growth is in focus
Trade tensions were the preeminent risk for respondents in the first quarter of 2019. While U.S.–China trade relations were the focal point, contacts also cited the risk of higher U.S. tariffs on imports of European autos and parts. Market participants were very focused on risks emanating from a generalized slowdown in growth, especially in China and Europe. Several other European risks were cited, including potentially unfavorable political dynamics, the prospect of a "no deal" Brexit, and a return of fiscal tensions in Italy.
On the domestic policy front, contacts viewed various aspects of U.S. monetary policy as potential sources of risk. During outreach at the start of the first quarter of 2019, contacts were focused on risks related to the potential for monetary policy to become overly restrictive; however, at the end of the quarter, some contacts noted the potential for excessive risk-taking, owing in part to a more accommodative monetary policy stance than had been previously anticipated. Many respondents raised concerns that the U.S. economic expansion was in its latter stages. While some respondents to the previous survey in the third quarter of 2018 had worried about the signals from the flat Treasury yield curve, a few contacts in the first quarter of 2019 volunteered that the temporary inversion of the curve—specifically, the temporary inversion between interest rates on the 3-month Treasury bill and the 10-year Treasury note that occurred in late March—was not a cause for concern. Some respondents pointed to the prolonged government shutdown as a potential harbinger of a challenging debt ceiling negotiation that could unsettle markets. Legal and market uncertainties surrounding the transition from contracts based on LIBOR (London interbank offered rate) were also cited by multiple respondents.
U.S. corporate concerns increase, while emerging market concerns recede
In the aftermath of credit market volatility in the fourth quarter, contacts increasingly focused on a turn in the credit cycle that could expose vulnerabilities in U.S. corporate debt markets, including the rapid growth of less-regulated private credit and a weakening of underwriting standards for leveraged loans. Contacts also highlighted the large volume of triple-B-rated corporate bonds and growth in retail participation in corporate credit, although respondents were less focused in the first quarter of this year on stretched credit valuations. Finally, in contrast to the third quarter of last year, only a few contacts mentioned risks emanating from emerging markets other than China, and the cited risks (for example, Argentina's elections and Venezuela's political instability) were not viewed as likely to generate meaningful spillovers to the United States.
1. Contacts included analysts and strategists at banks, investment firms, rating agencies, and political risk consultants as well as financial stability experts from central banks, think tanks, and multilateral agencies. The outreach this quarter was conducted in two periods (January and late March). Return to textReturn to text
Stresses emanating from Europe may pose risks for the U.S. financial system...
European economies have notable international financial and economic linkages, and a sharp economic downturn in Europe would affect banks, markets, and the global economy. First, heightened financial market volatility in Europe could spill over to global markets, including the United States, leading to a pullback of investors and financial institutions from riskier assets, which could amplify declines in equity prices and increases in credit spreads. In addition, spillover effects from banks in Europe could be transmitted to the U.S. financial system directly through credit exposures as well as indirectly through the common participation of globally active banks in a broad range of activities and markets. Finally, the consequent U.S. dollar appreciation and weaker global demand in such a scenario would depress the U.S. economy through trade channels, which could reduce earnings of some U.S. businesses, particularly exporters. Such effects could harm the creditworthiness of affected U.S. businesses, particularly those that already have high levels of debt.
Another prominent downside risk in Europe is a "no deal" Brexit, which remains a possible outcome later in the year, even after the European Council granted the U.K. government a further extension of the Brexit deadline until October 31. Brexit calls for a significant reorganization of financial arrangements between U.K. and EU residents, and without a withdrawal agreement, there will be no transition period. Despite extensive preparation and contingency planning by both the public and private sectors, addressing all of the many legal and regulatory details would be challenging. Consequently, a wide range of economic and financial activities could still be disrupted in Europe, which could prompt reactions in global markets as well.
Another near-term risk, which was cited in the November FSR, is elevated tensions between the European Commission and Italy over Italy's budget plan, which had raised the country's borrowing costs and prompted worries about its long-term fiscal sustainability. These concerns have been deferred for now, as Italy and the European Commission agreed on a budget plan for 2019, but Italy still faces longer-run fiscal challenges.
...and some risks in emerging market economies also could affect the United States
In China, the pace of economic growth has been slowing over the past several years, and a long period of rapid credit expansion has left the nonfinancial sector highly indebted and lenders more exposed in the event of a further slowdown. Against this backdrop, developments that significantly strain the repayment capacity of Chinese borrowers and financial intermediaries—including a further slowdown in growth or a collapse in Chinese real estate prices—could trigger adverse dynamics. Should significant problems arise in China, spillovers could include a broader pullback from risk-taking, declines in world trade and commodity prices, and U.S. dollar appreciation. The effects on global markets could be exacerbated if they deepen the stresses in already vulnerable EMEs. These dynamics could tighten conditions in U.S. financial markets and affect the creditworthiness of U.S. firms, particularly exporters and commodity producers facing weaker demand and lower prices.
That said, some of the potential contributors to near-term risks in EMEs that were cited in the November report are, for now, somewhat less prominent. These contributors include trade tensions and the effects of monetary policy normalization by the Federal Reserve and other advanced-economy central banks.
Market contacts cited the potential for a marked slowdown in economic growth as a salient risk to the financial system
Although most forecasters expect continued expansion, market participants cited the possibility of a marked slowdown in the U.S. economy as a potential risk to financial stability, as highlighted in the box "Salient Shocks to Financial Stability Cited in Market Outreach." Such a slowdown could affect the financial system through the balance sheets of businesses and households and through a decline in asset prices.
If the economy were to slow unexpectedly, profits of nonfinancial businesses would decrease, and, given the generally high level of leverage in that sector, such decreases could lead to financial stress and defaults at some firms. Also, given that valuations are elevated for a number of markets, investor risk appetite and asset prices could decline significantly. In addition to generating losses for the holders of the assets, a decline in asset prices could affect the financial system more generally either by impairing banks' ability to lend or by inducing runs on withdrawable liabilities.
That said, business interest expenses are currently low relative to earnings. Shocks are less likely to propagate to the financial system through the household sector because household borrowing is moderate relative to income, and the majority of household debt is owed by those with higher credit scores. Moreover, U.S. banks generally remain strongly capitalized and hold ample liquidity. The Federal Reserve's most recent stress tests indicate that the largest banks are sufficiently resilient to continue to serve creditworthy borrowers even under a severely adverse scenario.11 The broader financial system also has less leverage and funding risk compared with the period leading up to the financial crisis, so the effects of a decline in asset prices are less likely to be amplified through these vulnerabilities.
11. See Board of Governors of the Federal Reserve System (2018), Comprehensive Capital Analysis and Review 2018: Assessment Framework and Results (Washington: Board of Governors, June), https://www.federalreserve.gov/publications/files/2018-ccar-assessment-framework-results-20180628.pdf. Return to text