The Fed’s financial stability concerns before its June hike

At the end of last week, interest rate futures were pricing in a virtual 100% probability that the Federal Reserve will raise the federal funds rate 25 bps at the Federal Open Market Committee meeting that ends on Wednesday.

But the futures market was also expecting at least one more interest rate hike in 2017, with the market-implied probability of another hike by year-end at 55%. I think financial stability concerns play a key role in why the Fed is hiking. Here’s why.

US regulators have been sounding alarm bells about lax lending for some time, particularly in subprime auto, leveraged lending and commercial real estate. One of the reasons I wrote the last post on commercial real estate was because of this. CRE is an area that felt significant knock-on effects from the last downturn – and we were warned of problems in advance of the recession.

So it would be understandable if the Fed were concerned that low rates were skewing investment decisions and contributing to loose lending in CRE and other sectors. Moreover, with these financial stability concerns in mind, even in the face of persistently low inflation, the low level of unemployment gives the Fed cover to normalize policy.

Back in March, I wrote a post on a top US regulator’s concerns about loose credit standards. And while I focused on subprime auto in that piece, lax lending in commercial real estate was also an area of significant concern.

Here are some things the regulator said about commercial real estate – and remember this was put together in 2016:

• “Continued incremental easing in underwriting standards is a concern as banks strive to achieve loan growth and to maintain or grow market share. Easing of underwriting standards in commercial, CRE, and auto lending presents increasing credit risk”
• “Rapid CRE loan growth over the past year and recent underwriting reviews raise concern over the quality of CRE risk management, particularly managing concentrations.”
• “Supervisory reviews have identified concerns regarding the quality of underwriting, concentration risk management, and weaknesses in stress testing for CRE lending. These concerns are amplified by strong growth in CRE portfolios over the past three years. Strong CRE growth is evident in all sizes of banks, but CRE concentration build-up is primarily in smaller banks.”

That’s the last report we have seen from this regulator, the Office of the Comptroller of the Currency – or OCC. These are worrying trends if you think about how much commercial property deals are coming online right now.

Hiking rates now after a monster commercial real estate cycle has already developed is akin to closing the stable doors after the horse has already bolted. But this may be a concern of the Fed. Let’s see what the Spring 2017 OCC Risk Assessment says when it comes out. It should be out in early July.