Dramatic price swings in US financial markets have probably been exacerbated by a decline in liquidity, the Federal Reserve reported on Monday as it warned of a “higher than normal risk” that trading conditions will suddenly deteriorate.
The US central bank’s warning on liquidity — the ability to buy or sell an asset without influencing the price — follows several frenzied months in US markets. A sell-off has wiped trillions of dollars off the value of stocks and bonds while closing the door on new share listings and raising borrowing costs for consumers and corporations.
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 price.
The Fed on Monday said the ability to buy or sell at prices quoted by broker dealers had “deteriorated” and was worse than should be expected given levels of volatility. It added that the decline in liquidity might be compounded by brokers and high-frequency trading firms “being particularly cautious” given the market conditions.
“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 in the Fed’s financial stability report, which is published twice a year in May and November.
The swings in the price of everything from Treasuries to corporate bonds and stocks have also been driven in part by the Fed’s move to tighten monetary policy, as well as Russia’s invasion of Ukraine and the economic slowdown in China.
The central bank 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 $9tn balance sheet — which ballooned after it hoovered up bonds during the pandemic — as it steps up its efforts to rein in the highest inflation in roughly 40 years.
The prospect of higher interest rates has pushed the yield on the benchmark 10-year Treasury to its highest level since 2018. That rise has forced investors across the globe to reassess the value of many of the stocks they bid up to record highs over the past year, with the S&P 500 stock index down more than 16 per cent this year and the technology-heavy Nasdaq Composite declining more 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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