Fed says financial system holding up through turbulent year

By Howard Schneider and Michael S. Derby

(Reuters) -Even as global central banks rapidly tightened financial conditions this year, U.S. households, banks and businesses have so far been able to adapt, Federal Reserve Vice Chair Lael Brainard said as the Fed released its semiannual report on financial stability.

“Over the period, household and business indebtedness has remained generally stable, and on aggregate households and businesses have maintained the ability to cover debt servicing, despite rising interest rates,” Brainard said on Friday.

In written comments released along with the report, she restated concerns that the “rapid synchronous global monetary policy tightening,” along with surging inflation, the ongoing war in Ukraine and other risks, “could lead to the amplification of vulnerabilities, for instance due to strained liquidity in core financial markets or hidden leverage.”

The turbulent state of the world was captured in a survey of researchers and market participants who flagged an array of emerging concerns associated with the changes both in market conditions over the past year, and the worsening geopolitical situation.

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

Overall, however, the document described an economy adjusting, if sometimes fitfully, to the Fed’s rate hikes.

Banks maintained adequate capital, and while equity prices fell the report noted that real estate prices had largely held up.

“On balance, vulnerabilities arising from borrowing by nonfinancial businesses and households were little changed over the first half of 2022 and remained at moderate levels,” the report said. “Borrowing by businesses remained at high levels relative to gross domestic product (GDP) in the first half of 2022, but some measures of their ability to service that debt improved as the effects of rising interest rates were offset by higher business earnings.”

TREASURY MARKET CONCERNS REVISITED

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

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

Liquidity conditions were particularly poor for older vintages of bonds – so-called “off the run” securities – and for Treasury Inflation Protected Securities, the report found. “That said, market participants are not reporting major problems obtaining quotes or executing trades.”

The Inter-Agency Working Group on Treasury Market Surveillance – comprising 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 toward enhancing the resilience of the Treasury market, the Fed said, though it did not provide a timeline for that.

INTERNATIONAL TURBULENCE

The report also took note of the weakening economic conditions abroad from the war in Ukraine, China’s ongoing “zero-COVID” policy and its problematic property market, as well as persistent inflation, that could foster negative spillovers back to the U.S. economy or financial system in certain circumstances.

“Lower growth trajectories and rapidly rising interest rates as central banks respond 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 increased their use of leverage and derivatives, putting them at risk of facing strains with rates now rising rapidly and volatility on the rise, the report said.

The Fed nodded to the recent market upheaval in the United Kingdom, where in September a sharp rise in government yields forced pension funds that had taken on leveraged interest-rate positions to liquidate assets to meet margin calls, pushing yields up further.

“This adverse feedback loop prompted the Bank of England to introduce a temporary bond purchase program to improve market functioning,” the report said. “More broadly, periods of market volatility may raise concerns about funding pressures for some financial institutions.”

“Modern financial markets are interconnected, so stresses abroad could lead to strains in U.S. markets and challenges for U.S. financial institutions,” the report concluded.

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