Top of the Street: Banks fly through DFAST, oil leaks into the credit markets, recession risk runs below average and more

Banks came through the 2017 stress testing stronger than before. The drop in oil prices has hurt high yield. The risk of recession looks slightly below the average since 1980. And more. Contributions from DB, GS, JPM, WFC and Milepost.

Banking: Banks fly through DFAST
The 32 US banks subject to annual stress testing came through with flying colors, according to regulators last week. The banks forecast their performance through two 9-quarter stress scenarios and calculated capital ratios, asset value, loan losses, revenue, income and other metrics. The 2017 test showed the banks stronger than the year before. The average bank projected a loss of 330 bp of common equity this year compared to 390 bp last year. And the remaining equity cushion was 470 bp instead of 390 bp. The results look unlikely to move spreads on bank credit. See JPMorgan, US Fixed Income Markets Weekly: Cross Sector, 23 Jun 2017. (JPM, Milepost).

Markets: Oil leaks into the credit markets
The recent 16% drop in oil from its recent highs is leaking into the credit markets. Spreads on HY debt from energy issuers have widened an average of 55 bp in the last two weeks, according to Deutsche Bank, adding to 50 bp of widening in early May. Wider spreads in energy have dragged all HY wider, with HY ex-energy 5 bp wider and HY retail 35 bp wider. The pressure on HY in the last two weeks has not affected IG, however, with spreads 1 bp tighter. Soft oil prices have clearly hurt HY energy and broader concerns about soft inflation arguably have raised risk in wider HY. See Deutsche Bank, US Credit Strategy: High Yield Gives Back Six Months of Tightening, 23 Jun 2017. (DB, Milepost).

Economy/markets: Recession risk below average
The US economy has a 24% chance of going into recession in the next two years, according to Goldman Sachs, below the average 34% prevailing since 1980. The estimate comes partly from the bank’s review of causes for US recession since World War II. Tighter monetary policy and oil price shocks have contributed to recession most frequently, followed by swings in borrowing and investing, financial crisis and fiscal shocks. Although monetary tightening in response to an oil shock looks unlikely, tightening in general still poses risk. And a sudden swing in asset prices, borrowing and investment is another plausible cause. Still, recession risk has often been higher. See Goldman Sachs, US Economics Analyst: The Next Recession: Lessons from History, 23 Jun 2017. (GS, Milepost).

Markets: Slow growth in MBS may help the Fed taper
The growth of outstanding agency MBS has slowed sharply this year, dropping from net growth of $60 billion in January to just $15 billion in May. Most of the drop has come in Fannie Mae and Freddie Mac MBS, where net growth is down 81% and 97% respectively. Decelerating home prices and rising mortgage rates could keep growth in outstanding MBS low, buffering the impact of a likely Fed decision to begin reducing its MBS portfolio this fall. MBS spreads may only widen slightly as the Fed gets underway. See Goldman Sachs, The Mortgage Trader: Low interest rate volatility constructive for agency MBS, 23 Jun 2017. (GS, Milepost).

Economy: Demand outstrips supply in housing
Household formation continues to outstrip housing construction, putting solid demand behind new and existing home sales and home prices. New home sales in May hit a SAAR 610,000, a 9% jump over last year. Existing homes sales hit a SAAR 5.6 million, a new cyclical high. And home prices in April showed a 6.8% year-over-year gain, according to the index put out by the Federal Housing Finance Agency. All regions of the US saw healthy gains, ranging from 4.7% in the West North Central to 8.9% in the Mountain region. See Goldman Sachs, The Mortgage Trader: Low interest rate volatility constructive for agency MBS, 23 Jun 2017. (GS, Milepost).

Markets: Offices drive out retail in CMBS
Loans against office property have jumped to 35% of this year’s new private CMBS, according to Wells Fargo, up from 27% last year. Concern about retail property has driven its contribution from 27% to 22%, which, if it continues, will mark the lowest CMBS retail exposure on record. The contribution of multifamily property has fallen as agency CMBS take share in that sector, with the share of mixed use and industrial property rising. See Wells Fargo, CMBS Mid-Year 2017 Outlook, 22 Jun 2017. (WFC, Milepost).

Markets: Financing Treasury debt becomes a little more expensive
Usually the cost to finance Treasury debt falls a little below the fed funds rate, but not for most of June. The overnight rate for financing general Treasury debt has run as much as 10 bp above fed funds this month. That’s surprising since Treasury financing is a collateralized loan while fed funds is not. Part of the explanation may involve the $42 billion increase in Treasury positions at primary dealers over the last three months, leaving Street positions at nearly the highest levels in three years. Those balances need financing, requiring higher rates to draw the cash. Treasury financing also tends to rise before a Fed hike. Since the Fed hike, Treasury financing has dropped back below funds. See JPMorgan, US Fixed Income Markets Weekly: Short-Term Fixed Income, 23 Jun 2017. (JPM, Milepost).