Despite the recent jump in oil prices, the economy is not likely to see runaway inflation anytime soon, because...
The structure of the U.S. economy is fundamentally different today than in the ‘70s. For example...
Today there is greater labor productivity, a less energy-intensive U.S. economy, lower inflation expectations, global price competition, and the reduced unionization and wage-bargaining power of workers.
These factors may make it harder for price shocks to translate into a sustainable acceleration in inflation.
Despite Co-Dependent Trade Relationship, China Is Moving to Float Its Currency
Evolving global trade patterns have resulted in a “co-dependent” relationship between Asian exporters and U.S. consumers.
Because of this relationship, Asian nations have pursued currency management policies to keep prices low and bolster U.S. demand for Asian-made goods. Recycling of dollars raised from trade and currency management also are supportive of low U.S. interest rates.
The People’s Bank of China recently announced it will approach currency reform in a “gradual and steady manner,” perhaps indicating it would soon float its currency.
Still, the risk of an imminent dollar collapse remains remote—a sharp dollar devaluation would lift U.S. interest rates and import prices, weighing on U.S. economic growth.
Rising Interest Rates Pose a Particular Challenge for Mortgage Lenders
The 2003 refinancing wave has largely subsided following a brief “mini-boom” in first quarter 2004.
Lenders that increased capacity last year are now cutting overhead costs as volumes continue to tail off.
Unrealized gains on portfolios of long-term, mortgage-related assets turned to losses as rates rose in the second quarter, removing potential future earnings boosts that have consistently come from gains on the sale of assets since late 2000.
Net interest margins could narrow as rising short-term rates lift funding costs.
The lengthening duration of mortgage portfolios and a decline in mortgage loan growth likely will cause asset yields to rise more slowly than funding costs. Increases in the value of mortgage servicing rights will provide income for some mortgage banks.
Mortgage lenders will continue to look to riskier forms of residential lending, such as interest-only, high loan-to-value, and rehab loans.
CRE Portfolios Are Performing Well, but Losses Could Rise
Aggregate CRE concentrations continue to trend upward with the ratio of CRE to Tier 1 capital in second quarter 2004 at 157 percent but remain below the peak of 314 percent in 1987 at the peak of the last cycle.
Rising interest rates will push cap rates higher, causing increases in loan-to-value ratios. Higher interest rates will also cause debt-service coverage ratios to decline.
C&I Loan Quality Should Continue to Improve in 2004, but Weakening Underwriting Standards Are a Future Concern
Declining speculative-grade bond default rates suggest that C&I loan quality will continue to improve through 2004.
C&I loan demand has been weak since 2001 but is now strengthening. Many banks are targeting commercial customers more aggressively.
Spreads remain narrow on C&I loans for all firm sizes through second quarter 2004 primarily due to aggressive competition from both other banks and nonbank lenders.
Thus, competition for emerging C&I business could lead to a further loosening of underwriting standards. In addition, with rising interest rates, lenders may be tempted to cut into C&I margins to add business.
A dramatic slowdown in China’s economy could exert downward pressure on the export volumes of other Asian economies and world commodity prices, which could possibly result in a global recession and renewed global deflationary pressures.
Strong demand and tight excess production capacity has significantly raised the risk that a protracted period of elevated oil prices may derail the global economic expansion.
Third Quarter American Banker Survey Queried Bankers on Rising Interest Rate Concerns
Bankers did not express great concern for the effect of rising interest rates on near-term earnings, according to a recent American Banker/Insights Express survey.
Fifty-two percent felt rising rates would have a slight or significant positive effect on earnings, while 31 percent said rising rates would have a slight or significant negative effect.
Respondents ranked rising interest rates as the second-greatest risk concern. While 36 percent ranked fraud/privacy as the greatest risk, 20 percent felt rising interest rates posed the greatest concern.
Assessments of risks differed by institution asset size. Larger institutions—those over $20 billion in assets—viewed rising interest rate risk on par with disaster recovery risk at 15 percent.
Institutions with less than $20 billion in assets ranked rising interest rates as a higher concern at 22 percent. Both large and small institutions ranked fraud/privacy risks as the greatest concern facing their institutions.
Larger institutions ranked compliance with Basel II capital rules at 15 percent of their overall concerns.