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The sell-off in US equities in early August showed that highly leveraged hedge funds operating in a low-liquidity environment could magnify market shocks, the Federal Reserve said on Friday.
Financial markets fell sharply in the first week of August in what was seen then as a reflection of concerns over the US economy and rising interest rates in Japan, which turned against investors who had borrowed cheaply in yen in a popular trade known as the yen carry.
In a report, the Fed blamed August’s sudden jump in market volatility in part on “highly leveraged hedge funds” quickly selling down their positions to meet internal volatility targets — not margin calls from bank lenders.
“During this event, liquidity in the Treasury market, as well as in other markets, deteriorated markedly, but market conditions improved rapidly following favourable data releases the following week,” the Fed wrote in its twice-yearly financial stability report. “Nevertheless, this episode showed once again how high leverage can amplify adverse shocks.”
The Fed said measures of leverage averaged across hedge funds in the first quarter of 2024 were at or near the highest level since 2013, when it began tracking the volume of debt used by the funds.
The central bank said sparse market liquidity, especially during times of stress, could also amplify volatility and exacerbate the fallout.
Despite its warnings about indebted hedge funds, the Fed was sanguine about overall risks in the financial system, saying that in general banks “remained sound and resilient”.
Most domestic banks, the Fed’s report said, had high levels of liquid assets, and their reliance on uninsured deposits, a trigger for the regional banking turmoil last year, had decreased.
The Fed’s report, which reflected data and information available through November 4, showed that its contacts on Wall Street were concerned about the sustainability of the US debt burden, especially if the Treasury department had to keep issuing more government bonds to pay for it.
The Fed warned that this dynamic could put “upward pressure on long-term interest rates that could further damp growth and strain sovereign and private-sector borrowers”.
Fears about inflation and in turn higher for longer interest rates were also supplanted by concerns stemming from amplified geopolitical tensions, which the Fed said could lead to a “sudden pullback from risk-taking”.
“These developments could lead to declines in asset prices and losses for exposed businesses and investors, including those in the US,” the Fed added.
