Headwinds from recession keeping rates down
Weekly market view from New Oak
by Ron D’Vari, CEO, NewOak & James Frischling, President
U.S. housing prices and mortgage activities will remain highly sensitive to the Federal Reserve interest rate policy and guidance due to an anemic job market, low-quality new jobs and a lack of first-time home buyers.
In March, the Fed changed its interest rate guidance and removed its 6.5% unemployment rate bar before starting to adjust interest rates upward. The Fed highlighted that interest rates should be lower in the long run and implied true economic conditions justify long rates below 4-4.25% for some time due to headwinds from recession. We agree with the new policy because of the many structural changes that have occurred domestically and globally. These include demographic shifts, decreasing competitiveness of the U.S. economy and the high correlation of large emerging markets to U.S. economic health.
This has both positive and negative implications for U.S. home prices. On one hand, low, stable long-term interest rates should continue fueling the recovery in the housing and mortgage finance sectors. On the other hand, if the Fed is correct, the U.S. economy is not even close to where most people believe it to be and their high expectations will not be realized. This likely would mean a modest stock market correction and a dampening of home price rises. As a large portion of home purchases have been driven by speculating institutional and private investors the last two years, there could be a pull back. Let’s hope the Fed is not right in its long-term outlook.
Federal Reserve Stress Testing – Beyond the Numbers?
The Federal Reserve conducted its stress testing on the 30 most significant U.S. banks and five of those institutions failed. The tests are forward-looking exercises intended to ensure that the banks have sufficient capital to withstand losses and support operations during various adverse economic conditions. However, the tests are not solely quantitatively focused as the capital planning practices or the qualitative nature of the tests can also result in failure.
The importance of the qualitative side of the stress tests was clearly demonstrated in Citigroup’s recent failure as the bank had a 6.5% Tier I common ratio, well above the Fed’s 5% minimum. Still, the central bank found defects in Citigroup’s planning practices and of particular concern to the Fed were issues that had been flagged before. While none of the deficiencies would be deemed sufficiently critical to warrant failure in isolation, collectively they raised concerns regarding the reliability of the bank’s capital planning process.
The issue highlighted by Citigroup’s failure is the need for banks to understand and meet the Fed’s expectations. This, in turn, underscores the importance of the relationship between the banks and regulators.
On the quantitative side of the equation, the results of the annual stress tests shows that the banking system is now better capitalized and therefore safer. However, it’s the qualitative side that is holding some banks back, and the biggest deficiencies are in governance, risk management and internal controls in connection with capital planning. These areas are far less black and white. For the banks that failed on these fronts, a deeper understanding of what the Fed is looking for and expects is needed.