US Fed warns of worsening market liquidity in stability report

The Federal Reserve warned of deteriorating liquidity conditions across key financial markets amid rising risks from the war in Ukraine, monetary tightening and high inflation in a semi-annual report published on Monday (May 9).

“According to some measures, market liquidity has declined since late 2021 in the markets for recently issued US cash Treasury securities and for equity index futures,” the United States central bank said in its Financial Stability Report.

“While the recent deterioration in liquidity has not been as extreme as in some past episodes, the risk of a sudden significant deterioration appears higher than normal,” the report said. “In addition, since the Russian invasion of Ukraine, liquidity has been somewhat strained at times in oil futures markets, while markets for some other affected commodities have been subject to notable dysfunction.”

Inflation is projected to have moderated on both a monthly and annual basis, partly reflecting a dip in gasoline prices that have since picked back up. While inflation likely peaked in March at 8.5%, the hottest in four decades, price pressures are expected to remain elevated, keeping Fed officials on track to steadily lift borrowing costs in the months ahead.

High inflation readings, a slowing economy and aggressive tightening by the Fed to rein in soaring prices have weighed on risk appetite and valuations. Even if an outright recession is avoided, the outlook for U.S. stocks isn’t particularly bright, according to Goldman Sachs

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The US also issued a warning about liquidity — the ability to buy or sell an asset without influencing the price — following 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.

The Fed said the ability to buy or sell assets 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 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. 

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