Fed says financial system weathered turbulent year

By Howard Schneider and Michael S. Derby

(Reuters) – Even as global central banks have rapidly tightened financial conditions this year, U.S. households, banks and businesses have so far been able to adjust, the Reserve Vice Chairman said. federal government, Lael Brainard, as the Fed released its semi-annual report on financial stability.

“During the period, household and corporate indebtedness remained generally stable and, overall, households and businesses maintained their ability to service debt, despite rising interest rates. interest,” Brainard said Friday.

In written comments published with the report, she reiterated her concerns that “the rapid and synchronous tightening of global monetary policy”, together with soaring inflation, the ongoing war in Ukraine and other risks, “could lead to the amplification of vulnerabilities, for example due to tight liquidity in major financial markets or hidden leverage. »

The turbulent state of the world was captured in a survey of researchers and market participants who reported a range of emerging concerns associated with changes in market conditions over the past year and the deterioration of the situation. geopolitics.

More than half of survey participants cited liquidity and market stress as a “salient risk,” an issue that was not mentioned at all in the Fed’s May financial stability report. Concerns over Ukraine, inflation and oil prices remained high, but now added to this is a potential conflict between China and Taiwan, cited by 42% of survey respondents.

Overall, however, the paper depicted an economy that was adjusting, albeit intermittently at times, to Fed rate hikes.

Banks maintained adequate capital, and although stock prices fell, the report noted that house prices had largely held up.

“Overall, vulnerabilities arising from non-financial corporate and household borrowing changed little during the first half of 2022 and remained at moderate levels,” the report said. “Corporate borrowing remained at elevated levels relative to gross domestic product (GDP) in the first half of 2022, but some measures of its ability to service that debt have improved, the effects of rising interest rates interest being offset by rising corporate profits.”

REVISED TREASURE MARKET CONCERNS

The report noted deteriorating liquidity in the Treasury market, but said that overall it had run smoothly over the past few months.

“The likely predominant driver of recent low liquidity appears to be elevated uncertainty regarding the economic situation and the outlook for monetary policy,” the report concludes.

Liquidity conditions were particularly poor for older vintage bonds — so-called “off-the-run” securities — and for inflation-protected Treasury securities, the report said. “That said, market participants are not reporting major issues obtaining quotes or executing trades.”

The Interagency Task Force on Treasury Market Surveillance – made up of officials from the Fed Board, Treasury, New York Fed, Securities and Exchange Commission and Commodity Futures Trading Commission – is expected to provide an update on its progress towards improving the resilience of the Treasury. market, the Fed said, although it did not provide a timeline for that.

INTERNATIONAL TURBULENCE

The report also noted weakening economic conditions abroad due to the war in Ukraine, China’s ongoing “zero-COVID” policy and its problematic real estate market, as well as persistent inflation. , which could foster negative fallout on the US economy or financial system. in certain circumstances.

“Weaker growth trajectories and rapidly rising interest rates as central banks react to inflation have led to bouts of market volatility, and the dollar has appreciated significantly against most foreign currencies,” the report said.

During the long period of low and stable interest rates, some financial institutions have increased their use of leverage and derivatives, exposing them to the risk of coming under pressure with rapidly rising rates and rising volatility, according to the report.

The Fed gave a nod to the recent market turmoil in the UK, where a sharp rise in government yields in September forced pension funds that had taken leveraged interest rate positions to liquidate assets to meet margin calls, pushing yields even higher.

“This negative feedback loop prompted the Bank of England to introduce a temporary bond-buying program to improve market functioning,” the report said. “More generally, periods of market volatility can raise concerns about funding pressures for some financial institutions.”

“Modern financial markets are interconnected, so tensions abroad could lead to stress in US markets and challenges for US financial institutions,” the report concludes.

(Reporting by Howard Schneider and Michael S. Derby; Editing by Andrea Ricci)


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Don F. Davis