Where Does the Fed See Systemic Risk?

Where Does the Fed See Systemic Risk?

Short answer? Mutual funds and ETFs!

Longer answer, from the full text of today’s FOMC Minutes, which summarize the discussions held between January 27th and 28th. There’s some stuff in here about the potential for bubbles in commercial real estate while the volatility in FX and oil don’t bother them much at all.

The staff provided its latest report on potential risks to financial stability. Relatively high levels of capital and liquidity in the banking sector, moderate levels of maturity transformation in the financial sector, and a relatively subdued pace of borrowing by the nonfinancial sector continued to be seen as important factors limiting the vulnerability of the financial system to adverse shocks. However, the staff report noted valuation pressures in some asset markets. Such pressures were most notable in corporate debt markets, despite some easing in recent months. In addition, valuation pressures appear to be building in the CRE sector, as indicated by rising prices and the easing in lending standards on CRE loans. Finally, the increased role of bond and loan mutual funds, in conjunction with other factors, may have increased the risk that liquidity pressures could emerge in related markets if investor appetite for such assets wanes. The effects on the largest banking firms of the sharp decline in oil prices and developments in foreign exchange markets appeared limited, although other institutions with more concentrated exposures could face strains if oil prices remain at current levels for a prolonged period.

So basically, because Wall Street’s credit trading and market making operations have been neutered by Dodd-frank regulations, there’s some concern that there will be no one there in the marketplace to cushion the blow if bonds go Bid Wanted. If people start blowing out of fixed income ETFs en masse because rates are rising, there may be more volatility than the bond market is currently accustomed to. It’s a legitimate concern. The dress rehearsal for this happened 20 months ago in May 2013 and it wasn’t pretty.

Shoutout to Matt Boesler for picking up on this comment first.

If you’re interested, the full text can be found below.

Source:

The Fed is prepared to keep rates at zero for longer (Business Insider)