Janet Yellen reveals concerns for U.S. recovery

May 8, 2014, 2:56 PM UTC
Janet Yellen, chair of the U.S. Federal Reserve
Janet Yellen, chair of the U.S. Federal Reserve, listens during a Financial Stability Oversight Council (FSOC) meeting with at the U.S. Treasury in Washington, D.C., U.S., on Wednesday, May 7, 2014. The FSOC today unanimously approved its 2014 annual report, which was developed collaboratively by the members of the Council and their agencies and staffs. Photographer: Andrew Harrer/Bloomberg via Getty Images

FORTUNE — Federal Reserve Chair Janet Yellen played it mostly safe in her appearance before Congress Wednesday morning, attempting to minimize any negative impact her testimony could have on a strengthening stock market.

But in her prepared remarks and in the questions that followed, Yellen pointed out a few trouble spots in the economy that could eventually be of great concern to investors.

Yellen has come a long way since her first press conference in March. Back then, she committed the grave sin of quantifying one of the carefully constructed — and cryptic — statements prepared for her by her staff. But on Wednesday, Yellen stuck to the script, refusing to give any personal views on interest rate policy or the economy in general. Senators tried to bait her into quantifying her views on what constitutes full employment or when she thinks interest rates will rise, but she didn’t budge.

While Yellen clearly played it safe on Wednesday, she did manage to reveal a few “concerns” regarding the strength of the ongoing economic recovery. One of those dealt with “heightened geopolitical tensions” in the emerging markets. This was most likely a reference to the recent troubles between Russia and the West over the fate of Ukraine — though she didn’t give any specifics.

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The Fed may not be able to control Vladimir Putin, but it can control interest rates. While Yellen made it clear on Wednesday that the Fed’s low interest rate policy wouldn’t be changing anytime soon, she did allude to concerns about its effectiveness in stimulating the economy.

Yellen noted in her testimony that the recent recovery in housing had flattened out and that it could prove “more protracted than currently expected rather than resuming its earlier pace of recovery.” She said the housing situation would require “close observation, “which is Fed-speak for, “we’re worried about this.”

The worries are justified as it seems to throw some cold water on the Fed’s low interest rate policy. With rates still near historic lows, people should be running to get a mortgage, but mortgage issuance is at a historic low. Oh, and the banks are lending — people just aren’t interested in taking the plunge.

There are tons of reasons for the stall in the housing market. Prices may have gone up too fast, too high, overshooting buyer incomes. After all, wage growth remains flat, so it stands to reason that many people aren’t keen on buying a house right now.

As such, the Fed seems to be telling the markets that it doesn’t hold all the cards when it comes to the housing recovery. Sure, super low rates can motivate some people to buy, but if asset prices are inflated or out of reach, then interest rates are irrelevant.

The Fed’s low interest rate policy isn’t just about propping up the housing market — it is also about encouraging investment. While that sounds like a noble endeavor, it comes with its own consequences. Indeed, Yellen noted that the policy forces investors to “reach for yield,” leading some to take on “increased leverage, duration risk, or credit risk.”

Yellen noted the uptick in demand in the “lower-rated corporate debt markets, where issuance of syndicated leveraged loans and high-yield [junk] bonds has continued to expand briskly.” As a result, she acknowledged that “spreads have continued to narrow, and underwriting standards have loosened further.”

Those are both troubling developments, which could have a profoundly negative impact on the economy if they get out of hand. Here, Yellen seemed to get a bit defensive. She noted that even though there had been a massive expansion in shady debt as a result of Fed policy, “these increases appear modest to date — particularly at the largest banks and life insurers.”

So, no problem here, right? Well, not exactly.

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While Yellen believes the junk bond market hasn’t gotten out of hand “to date,” that doesn’t mean it will stay that way forever. By simply acknowledging this issue in her testimony, Yellen seems to be putting Wall Street on notice that the Fed will be watching the junk and leveraged loan markets very closely from now on.

A near-record $322.3 billion worth of high-yield corporate debt was issued in the U.S. in 2013. Demand was so great that spreads — the difference in yield between “risk free” treasuries and junk — fell to all-time lows.

This junk bond mania isn’t showing any sign of letting up. In the first four months of 2014, $114 billion worth of junk debt was issued to investors, which is on par with what was issued during the same period last year, according to S&P Capital IQ.

Meanwhile, there has also been an uptick in demand for risky leveraged loans and collateralized loan obligations. As demand has increased for these products, quality has decreased. An analysis conducted by Moody’s found that credit quality in new U.S. CLO transactions has “deteriorated” since April 2012 due to an increase in the proportion of B3 rated loans. B3 is six notches below junk, making it super subprime.

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