Fed traces financial market volatility to oil

OREANDA-NEWS. February 12, 2016. Developments in oil markets are among key factors explaining recent volatility in financial markets, the Federal Reserve said today.

But the Fed is not worried about a potential contagion effect on the US banking system, noting that the largest US banks have a limited exposure to oil and natural gas drilling.

The volatility in financial markets since late December relates to uncertainties regarding the Chinese exchange rate policy and the "uncertainties around the price of oil," Federal Reserve chair Janet Yellen told the House Financial Services Committee today. Yellen was presenting the Fed's semi-annual monetary policy report to Congress.

The Fed said that US investors have taken a hit from the fall in crude oil prices as a result of declines in US energy companies' equity values, as well as the exposure to equity markets in Brazil and other commodity-exporting countries.

About 25pc of outstanding corporate debt in emerging markets is issued by oil and mining companies, according to the IMF.

The potential slowdown of the Chinese economy and oil price volatility are also behind the declines in yields on long-term US Treasury securities. Participants in the US Treasury market were particularly attentive to turbulence in Chinese financial markets and to fluctuations in oil prices, the Fed said in its report.

The yield on US Treasury's 10-year notes fell to 1.74pc yesterday from 2.15pc on 1 December 2015, even though the Fed in December raised its federal funds rate.

The Nymex light, sweet crude front-month contract settled at \\$27.94/bl yesterday, down from \\$41.85/bl in early December.

Debt levels in the US oil industry have risen to historical highs, creating "somewhat elevated risks of distress for some business borrowers," the Fed's policy report said. But debt growth slowed in late 2015.

Most distressed debt issued by oil and other energy firms is held by non-bank institutions, such as private equity and hedge funds and insurance companies. The direct exposure of the largest US banks to the oil sector and to emerging market economies is limited, the Fed said.

"Financial conditions in the US have recently become less supportive of growth," Yellen said today, citing stock market declines, appreciating dollar and higher borrowing rates for the riskier borrowers.

The Fed as a result is reluctant to follow up on the December increase in the federal funds rate. That should be welcome news to US shale producers, many of which have loaded their balance sheets with debt.

The Fed in December set a target range for the federal funds rate of 0.25 to 0.5pc and indicated a strong possibility of further increases in 2016. Corporate debt yield spreads generally move in tandem with the Fed target.

The Fed in December was expected to increase the interest rates four times in 2016. But financial markets at present expect one or two increases at most, former US treasury secretary Larry Summers said today during a speech at Washington-based Johns Hopkins University's School of Advanced International Studies.

A survey of economists with major US banks by the American Bankers Association last week resulted in a forecast of three more increases this year, until it reaches a range of 1pc to 1.25pc.