A recent semiannual survey conducted by the Federal Reserve revealed that escalating international trade tensions and broad policy uncertainty now rank as the foremost risks to the stability of the U.S. financial system, displacing longer-standing concerns such as debt sustainability and asset-valuation pressures. The report, compiled from interviews with 22 academics, investors and financial professionals, shows a dramatic shift in the risk landscape since the previous survey, with nearly three-quarters of respondents pointing to global trade conflicts—primarily linked to aggressive tariff measures—as a critical vulnerability .

Fed Survey Highlights Top Financial Stability Threats

Seventy-three percent of survey participants identified disruptions from international trade disputes, especially U.S. tariff actions and potential retaliation, as the most significant risk to financial stability—more than double the proportion cited six months earlier. Many respondents warned that while incremental tariffs might be absorbed by firms with robust balance sheets, the prospect of a full-blown, escalating trade war could trigger widespread volatility across asset classes and supply-chain bottlenecks. Survey comments highlight concern over sudden shifts in government spending priorities and uncertainty about the United States’ future role in global economic forums, both of which could undermine confidence in market-access rules and contractual commitments.

Half of those surveyed named general policy unpredictability—encompassing fiscal, regulatory and monetary decisions—as a top stability risk, up sharply from the last report. Respondents noted that abrupt changes in tax, trade or regulatory regimes can create “fear events” for corporate boards and fund managers, leading to sudden re-pricing of securities and widening of credit spreads. The report emphasizes that while measured policy shifts can guide markets, erratic or contradictory announcements risk undercutting investor planning horizons and exacerbating cyclical downturns.

Although trade and policy upheaval dominated concerns, nearly three-quarters of survey contacts reaffirmed that the long-term sustainability of U.S. public debt remains a substantial risk, particularly as Treasury issuance climbs to fund persistent budget deficits. With the federal debt-to-GDP ratio near record highs, some participants warned that dwindling foreign appetite for Treasury securities—exacerbated by geopolitical friction—could push yields sharply higher, creating a self-reinforcing spiral of borrowing costs and fiscal strain .

Other Emerging Vulnerabilities

The share of respondents worried about the proper functioning of U.S. Treasury markets rose to 27 percent, compared with 17 percent in the previous survey, spotlighting concerns about liquidity during episodes of stress. Recent episodes of sharp price swings in on-the-run Treasuries and derivative basis trades, driven by hedge-fund leverage and thin dealer inventories, have underscored the market’s fragility amidst shifting monetary policy signals . Analysts caution that unless structural reforms—such as expanded central clearing or revised capital rules for primary dealers—are implemented, future bouts of volatility may prove more severe.

Despite prolonged volatility in early April, the Fed observed that equity and fixed-income markets overall remained orderly, with bid-ask spreads and trading volumes snapping back quickly after mini-flash events. However, asset valuations in both commercial and residential real estate, as well as equities, persist near multiyear highs relative to historical earnings and rental-income metrics, raising the risk that a pronounced correction could imperil portfolio balance sheets. In commercial real estate, vaccination-led occupancy gains have stabilized prices, but sector leverage—and exposure to remote-work trends—remains an area of caution.

The survey confirmed that U.S. banks are maintaining robust capital and liquidity buffers, lending that remained sound even through early-April liquidity strains. Yet growth in bank credit commitments to less-regulated nonbank entities—such as finance companies and private-credit vehicles—continues unabated, raising questions about off-balance-sheet leverage and contingent liabilities in the broader financial system. Participants cited the need to monitor nonbank funding channels closely, given their historical role in amplifying stress during past crises.

Survey respondents flagged the elevated leverage levels at large hedge funds—particularly those pursuing relative-value trades in Treasury and credit markets—as a notable vulnerability. According to industry data, basis-trade positions in Treasuries alone reached roughly $800 billion in notional exposure in April, intensifying risks of sudden unwinds if funding conditions tighten or price dislocations occur. While leverage reportedly dipped following early-April market moves, the survey underscores that sustained high leverage continues to pose systemic risks without adequate margin and haircut frameworks.

Expert Views and Implications for Policy

Amid concerns over market functioning, analysts have weighed how the Fed might deploy its crisis-response toolkit—ranging from the Standing Repo Facility and discount window to large-scale asset purchases—if liquidity conditions deteriorate again. While Fed Chair Jerome Powell has emphasized that intervention is not warranted while markets remain orderly, the existence of “off-ramps” such as temporary repo facilities provides a degree of reassurance to participants. Several experts advocate for a dedicated bond-buying mechanism to stem idiosyncratic breakdowns without signaling a broad shift in monetary policy.

Most survey contacts urged policymakers to pursue structural enhancements, including greater transparency in nonbank credit exposures, stronger capital requirements for leveraged intermediaries and refined clearing mandates for Treasury derivatives. Recommendations also include expanding data-reporting requirements for large-scale basis trades and standardizing margin practices across bilateral OTC markets to reduce counterparty-risk uncertainty.

The Fed’s insights reflect a delicate balance between fostering financial stability and supporting economic growth amid policy shifts. While trade and fiscal disagreements present immediate hazards, maintaining accommodative financing conditions and safeguarding core market plumbing remain essential to avoid unintended credit market disruptions. As global trade policy and domestic fiscal choices continue to evolve, the central bank’s vigilance over emergent vulnerabilities will be critical to sustaining confidence across financial markets.

This survey underscores how swiftly policy-driven shocks can reshape the risk profile of the U.S. financial system, highlighting the importance of both proactive surveillance and readiness to deploy liquidity tools should the next market tremor strike.

(Adapted from TheDailyStar.net)

Categories: Economy & Finance, Geopolitics, Regulations & Legal, Strategy