What The Fed's Latest Report Tells About Risks, Vulnerabilities and Liquidity

The U.S. Federal Reserve has stated in its financial stability report that economic, financial, and geopolitical risks have risen across market economies contributing to asset price declines and periods of significant market volatility.

These developments and future shocks have the potential to be amplified by vulnerabilities associated with asset valuations, borrowing by households and businesses, financial-sector leverage, and funding risks, it said.

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“Higher interest rates and a weaker outlook for the economy led prices of financial assets to fall amid heightened volatility, but real estate prices remained elevated. Measures of equity prices relative to expected earnings declined. Risk premiums in equity and corporate bond markets were near the middle of their historical distributions,” the report said.

It highlighted that borrowing costs continue to rise and inflation is reducing real incomes -- a combination that may pose risks to the ability of some businesses and households to service their debts, especially in the event of further adverse shocks to income or inflation.

Market participants are keenly awaiting the CPI report set to be released later this week. The SPDR S&P 500 ETF Trust SPY ended Friday’s session 1.44% higher while the Vanguard Total Bond Market Index Fund ETF BND gained 0.03%.

Short-Term Funding: The central bank pointed out that short-term funding markets continue to have structural vulnerabilities, as some markets and institutions remain vulnerable to large and unexpected withdrawals, especially considering the highly uncertain outlook. “Funding risks at domestic banks are low, given their large holdings of liquid assets and limited reliance on short-term wholesale funding,” it added.

Liquidity: The Federal Reserve also pointed out that market liquidity—the ability to trade assets without a large effect on market prices—remained low in several key asset markets since the May report. “Low liquidity amplifies the volatility of asset prices and may ultimately impair market functioning. It could also increase funding risks to financial intermediaries that rely on marketable securities as collateral. These potential amplification channels may interact with leverage in the financial system,” it warned.

Consequences of Russia’s invasion of Ukraine, stresses in China, the strength of the dollar, and other developments abroad could lead to adverse developments in some economies, which could affect U.S. financial stability, it added.

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