Market liquidity drought raises alarm bells inside Fed

Thu Apr 23, 2015 11:30am EDT
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By Michael Flaherty and Jonathan Spicer

WASHINGTON/NEW YORK (Reuters) - Sections of the U.S. financial system that may be vulnerable to investor panic are raising concerns inside the Federal Reserve, as policymakers preparing for the first interest-rate hike in nearly a decade seek to ensure the market is ready and able to handle it whenever it happens.

Years of Fed bond-buying and new bank rules are seen to have left the ultra-liquid U.S. Treasuries market more vulnerable to an abrupt selloff. But in particular, the Fed is worried whether the booming asset management industry can withstand a run of redemptions in a financial crisis.

Chief among the Fed's concerns, increasingly voiced in public remarks, is that certain funds held by individuals and institutions will not have the underlying assets sufficient to back investors cashing out in a panic. This lack of liquidity would expose investors and the economy to sharp price swings.

Meanwhile, bond inventories at primary dealers have plunged alongside a drop in overall Treasury securities in circulation. The fall in liquidity across portions of the bond market comes amid a jump in volatility, making it vital that Fed officials telegraph their tightening plans well ahead of time.

The central bank's nightmare scenario is in surprising markets, exposing investors to the liquidity risks it fears, and causing a spike in borrowing costs that hurts economic growth.

"Some open-ended mutual funds offer daily withdrawal privileges but invest in assets that take longer to sell and settle," Fed Vice Chair Stanley Fischer said in a speech last month. Fed Governor Daniel Tarullo and Atlanta Fed President Dennis Lockhart have offered similar warnings about liquidity in the last few months.

Asset managers have said they are systemically safe. But Fed officials have noted a surge in asset management inflows and concentration. One example is fixed income exchange-traded-fund assets, which reached $246 billion in 2013 from their inception in 2002, according to Greenwich Associates.

New York Fed President William Dudley has warned that investors are less inclined to hold liquid assets as memories of the 2007-2009 financial crisis fade.   Continued...

The United States Federal Reserve Board building is shown in Washington October 28, 2014. REUTERS/Gary Cameron