Fed's Yellen Reiterates Concern Over CRE

In today’s semi-annual speech to Congress, FOMC Chairwoman Yellen reiterated concern over some aspects of the commercial real estate market, highlighting “notable” valuation pressures in the commercial real estate sector, “to which some small banks have substantial exposures.”

The monetary policy report also suggested that while “financing conditions in the commercial real estate (CRE) sector have remained accommodative overall,” that there have been some “signs of tightening.” Growth of CRE loans at banks remained strong during the first half of the year. However, banks indicated that they had further tightened their lending standards on CRE loans in the first quarter of 2016, according to the Senior Loan Officer Survey conducted in April.

Additionally, spreads on interest rates for CRE loans relative to 10-year swap rates and to yields on commercial mortgage-backed securities, which rose sharply earlier this year, “have retreated significantly,” over the past several months, even as these financing spreads “remain well above their historical average levels.”

What else is on the “worry list” besides valuation pressures in CRE?” Here’s a short list:

  • Elevated leverage of nonfinancial corporations; lower-rated firms are potentially vulnerable to “adverse developments” in the credit markets
  • Prolonged low energy prices have weakened the financial performance of firms in the energy sector
  • Equity market valuation pressures have increased as expectations for corporate earnings have been revised downward
  • External shocks that could threaten financial stability, including the impact of a decision by the United Kingdom to leave the European Union (results this Friday AM.)

On a positive note, domestic financial firms and markets have shown a good degree of resilience despite heightened financial volatility at the beginning of the year. (Recall that the Dow had been down as much as 12% YTD through mid-February.) Banks’ capital and liquidity ratios have remained at high levels relative to historical standards, and debt growth in the household sector has been modest.

What is the Fed likely to watch over the next three weeks?

  • The Brexit results on Friday AM (6/24); a decision to leave could cause dollar strengthening and capital flight from the UK
  • New orders for capital goods (6/24); business spending has been unusually weak during this recovery
  • The last revision to Q1 GDP (6/28): the consensus is for a slight increase from 0.8% to 1.0%, although such growth would still be well below trend. (Note that the data are less significant than other releases since they do not tell us anything about the outlook for H2.)
  • May personal spending (6/29): Spending growth has been somewhat muted relative to the pace of income growth
  • FOMC minutes from the June 14–15, 2016 meeting (7/6); will give more granular details into what drove the most recent downshift in the outlook for monetary policy tightening
  • June payrolls report (7/8): will shed light as to whether the weak May report was an aberration or the start of a real slowdown

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Heidi Learner

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