Wall Street will jump at anything at the moment – as we saw in Monday’s big sell off which saw global shares suffer their worst day since June, 2020.
One of the factors in the sell down on Monday was the observation by the Fed in its first Financial Stability Report for 2022 that a sharp increase in interest rates to control fresh inflation shocks would pose a risk to the American economy.
That is hardly ‘new news’, what did take people reading the report by surprise was an additional observation that there is a “higher than normal” chance that trading conditions in US financial markets will suddenly deteriorate.
“Further adverse surprises in inflation and interest rates, particularly if accompanied by a decline in economic activity, could negatively affect the financial system,” the Fed said in the report.
The Fed said consumer finances might be hit by job losses, higher interest rates and lower house prices, the Fed cautioned, with businesses also facing “higher delinquencies.
“A sharp rise in interest rates could lead to higher volatility, stresses to market liquidity, and a large correction in prices of risky assets, potentially causing losses at a range of financial intermediaries,” the Fed reported.
That would reduce “their ability to raise capital and retain the confidence of their counterparties,” the central bank added.
Again those observations are not new – they are the usual examples of fallout from a rise in rates over time – sharp or more sedate – as overstretched businesses and consumers can’t take the additional pain.
But the context was important – shares tanking by the hour and the central regulator warns of a possible sudden slide and worse.
These general observations though were qualified in the report with the Fed commenting “it is noteworthy that households and businesses have decreased their borrowing as a percentage of gross domestic product (GDP), and currently appear to have resources to cover debt burdens, which is an important aspect of resilience in an environment of rising interest rates.”
The Fed and rising rates do have something of a history in the past 30 years.
Rising interest rates in 1994 – a 1.75% jump in the federal funds rate in six months – caused a sudden and sharp slide in markets and in borrowing costs and sent Orange County in California broke.
But it works both ways – in 1998 a series of rate cuts (totalling 1%) tried to ease pressures emerging as the tech and net boom expanded. But 0.75% of rises in the federal funds rate in early 1999 came too late and with three further increases in 2000, including a half a per cent rise in May that year (to 6.5%) should have really happened the previous year.
The end result was the tech and net sectors and the wider market had already started sliding in March, 2000 and the 0.50% rise happened three months later, so the Fed actually tightened into a developing market collapse.
Now the Fed has lifted the federal funds rate 0.75% so far in 2022 with more to come.
Inflation in the US in 1999 averaged 2.31% while the next year, it averaged 3.36%. The US inflation rate has averaged 2.6% from 2000 to the start of 2022. Now it is more than 8% on a headline basis and 6% on a core basis – the Fed’s target is 2%.
While the Fed starts this rate rise program with inflation considerably higher, the jobless rates of 4% for 1999 and 3.9% for 2000 aren’t much different to current levels.
The more important warning from the Fed was about liquidity in the financial system – that is the ability to buy or sell an asset without influencing the price.
Bond yields are rising – meaning big losses for investors of all sizes, several trillion dollars have been wiped off the value of stocks in the US and elsewhere and rising inflation and prices for key commodities such as oil and gas has sucked large amounts of cash from consumers and businesses as well and transferred them to small groups, like energy companies.
Complicating matters is an issue never been seen before at a time of financial stresses – a pandemic that continues to impact economies large and small – none larger though than China’s, the world’s second biggest.
The record low rates, enormous stimulus and support spending in 2020 and 2021 helped soften the impact of the virus and the various control measures, but it did leave a lot of liquidity and leverage in financial systems, which is rapidly vanishing, if the Fed’s warning is any guide.
The surge in bond yields, inflation and market volatility – especially since the Russian invasion of Ukraine in late February, has shut out new stockmarket share listings, limited share sales by existing companies and lifted borrowing costs for consumers and corporations.
“Declining depth at times of rising uncertainty and volatility could result in a negative feedback loop, as lower liquidity in turn may cause prices to be more volatile,” Fed policymakers wrote in the report.
Conditions in Treasury, commodity and equity markets have been noticeably poor this year, with traders reporting that they have struggled to conduct even relatively small trades without influencing prices.
The Fed last week delivered its first half-point rate rise since 2000 and is set to implement additional increases of the same magnitude at its next two policy meetings. In June, it will also start to shrink its $US9 trillion balance sheet as it steps up its efforts to rein in the highest inflation in roughly 40 years.
All this means tighter liquidity conditions, higher market rates (the US Treasury 10-year bond yield has topped 3.2%, the highest it has been since 2018). The S&P 500 has fallen more than 16% this year and Nasdaq is down 25% in 2022 and more than 28% since its peak last November.
And for Australia and many Australian resource companies, there’s a further warning – led by the Fed, regulators including the Reserve Bank here are watching commodity markets more closely than they have for a while, especially since the Russian invasion of Ukraine.
“Russia’s unprovoked war in Ukraine has sparked large price movements and margin calls in commodities market and highlighted a potential channel through which large financial institutions could be exposed to contagion,” Lael Brainard, the Fed’s vice-chair, said in a statement alongside the report on Monday.
“The Federal Reserve is working with domestic and international regulators to better understand the exposures of commodity market participants and their linkages with the core financial system.”
We have already seen nickel prices collapse on the London Metal Exchange (LME) when a hedging/short position by a Chinese nickel company – the world’s biggest (Tsingshan) – go wrong when prices spurted higher in early March, jumping 250% in a matter of days to more than $US101,000 a tonne.
The Hong Kong-owned LME eased pressure on Tsingshan (which was being funded by at least two big Chinese banks and several large western banks) by cancelling thousands of orders made the day of the price spike and collapse.
That has set off warning bells among prudential and financial regulators because many of the hedging transactions are what’s called ‘over the counter’ and not visible until something bad happens and unknown losses suddenly become very visible and known.
The other problematic area is cryptocurrencies and the current huge sell off, especially in bitcoin, is also being watched closely for any spillover back into the real world of finance.
In its report, the Fed also reiterated concerns over financial risks posed by stablecoins, a fast-growing type of cryptocurrency that’s designed to maintain a steady value in relation to a hard currency like the US dollar. The coins are “vulnerable to runs” and there’s a lack of transparency around the assets that are used to back the tokens, the Fed said.
“Additionally, the increasing use of stablecoins to meet margin requirements for levered trading in other cryptocurrencies may amplify volatility in demand for stablecoins and heighten redemption risks,” the report said.
