US Financial Markets Thriving Despite Extended Fed Policy
Even with the Federal Reserve maintaining interest rates at 23-year highs, the United States financial markets are flourishing. This prolonged policy decision has not resulted in the usual systemic issues observed in previous economic cycles. Here are three key reasons why the U.S. financial markets are excelling under these circumstances.
Privatization of Risk in U.S. Financial Markets
The Federal Reserve’s extended hold on interest rates has prompted private entities to take on more financial risks. This shift is evident as private firms and investors are increasingly exploring high-yield bonds and private credit markets.
In the first quarter of 2024, U.S. high-yield bond issuance surged to $68.6 billion, nearly doubling the $35.2 billion raised in the first quarter of 2023 and more than doubling the $33.4 billion recorded in the fourth quarter of 2023. This robust performance highlights investors’ appetite for higher returns in a low-rate environment.
Unlike previous crises like the tech stock crash in 2000 and the subprime mortgage crisis in 2007, the current financing landscape is primarily driven by private markets. Pension funds, endowments, family offices, and wealthy individuals are more directly engaged in lending through non-bank institutions. This transition reduces the likelihood of widespread panic caused by issues in private credit markets. Problems like missed payments are kept private, preventing investors from behaving like a herd. While the International Monetary Fund (IMF) has raised concerns about transparency and underwriting standards, the decreased risk of abrupt funding shortages provides stability.
Government Debt Fuels Growth in U.S. Financial Markets
In the past, excessive corporate and household debt has led to economic downturns. However, this time, the Fed’s balance sheet has played a crucial role by contributing its largest share to GDP growth in over a decade—accounting for 99% of the U.S. GDP, according to the Congressional Budget Office. This leveraging of the Fed’s balance sheet is inherently less risky compared to borrowing sprees by the private sector.
Despite worries about the sustainability of rising debt levels, experts like Seth Carpenter, chief global economist at Morgan Stanley, believe that the U.S. has not yet reached a tipping point where issuing more debt would lead to higher yields. The strategic use of government debt has propelled growth without the same risks associated with private sector leverage.
Fed’s Strategic Risk Management
The Federal Reserve is adept at balancing risks to uphold stability in the U.S. financial markets. Despite raising interest rates aggressively and reducing its bond portfolio, the Fed remains vigilant about potential downside risks. The central bank’s provision of emergency funding during the Silicon Valley Bank collapse in March 2023 underscores its dedication to preventing a financial crisis.
Fed Chair Jerome Powell and his team have ruled out further rate hikes, concentrating instead on sustaining a robust economy and controlling inflation. This cautious approach has curtailed market volatility and eased financial conditions. Nevertheless, prolonged high interest rates could still cause strain, particularly in areas like lending to low-income households by fintech firms, where visibility is limited.
The U.S. financial markets are successfully weathering the extended Fed policy due to the privatization of risk, government debt-driven growth, and the Federal Reserve’s strategic risk management. These factors have safeguarded stability and averted the systemic issues experienced in previous economic cycles. However, ongoing vigilance is crucial to addressing potential risks and ensuring continued economic well-being.
