Fed warns of ‘negative feedback loop’ as market liquidity deteriorates

Dramatic value swings in US monetary markets have in all probability been exacerbated by a decline in liquidity, the Federal Reserve reported on Monday because it warned of a “higher than normal risk” that buying and selling circumstances will abruptly deteriorate.

The US central financial institution’s warning on liquidity — the power to purchase or promote an asset with out influencing the value — follows a number of frenzied months in US markets. A sell-off has wiped trillions of {dollars} off the worth of shares and bonds whereas closing the door on new share listings and elevating borrowing prices for shoppers and firms.

Conditions in Treasury, commodity and fairness markets have been noticeably poor this 12 months, with merchants reporting that they’ve struggled to conduct even comparatively small trades with out influencing value.

The Fed on Monday stated the power to purchase or promote at costs quoted by dealer sellers had “deteriorated” and was worse than must be anticipated given ranges of volatility. It added that the decline in liquidity may be compounded by brokers and high-frequency buying and selling companies “being particularly cautious” given the market circumstances.

“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,” policymakers wrote within the Fed’s monetary stability report, which is revealed twice a 12 months in May and November.

The swings within the value of all the pieces from Treasuries to company bonds and shares have additionally been pushed partially by the Fed’s transfer to tighten financial coverage, in addition to Russia’s invasion of Ukraine and the financial slowdown in China.

The central financial institution final week delivered its first half-point price rise since 2000 and is about to implement extra will increase of the identical magnitude at its subsequent two coverage conferences. In June, it should additionally begin to shrink its $9tn steadiness sheet — which ballooned after it hoovered up bonds throughout the pandemic — because it steps up its efforts to rein within the highest inflation in roughly 40 years.

The prospect of upper rates of interest has pushed the yield on the benchmark 10-year Treasury to its highest degree since 2018. That rise has compelled traders throughout the globe to reassess the worth of most of the shares they bid as much as document highs over the previous 12 months, with the S&P 500 inventory index down greater than 16 per cent this 12 months and the technology-heavy Nasdaq Composite declining greater than 25 per cent.

“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, reducing their ability to raise capital and retain the confidence of their counterparties,” the Fed warned in its report.

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