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The sell-off in US equities in early August confirmed that extremely leveraged hedge funds working in a low-liquidity atmosphere might amplify market shocks, the Federal Reserve stated on Friday.
Monetary markets fell sharply within the first week of August in what was seen then as a mirrored image of considerations over the US economic system and rising rates of interest in Japan, which turned towards traders who had borrowed cheaply in yen in a well-liked commerce often known as the yen carry.
In a report, the Fed blamed August’s sudden bounce in market volatility partly on “extremely leveraged hedge funds” shortly promoting down their positions to satisfy inner volatility targets — not margin calls from financial institution lenders.
“Throughout this occasion, liquidity within the Treasury market, in addition to in different markets, deteriorated markedly, however market circumstances improved quickly following beneficial information releases the next week,” the Fed wrote in its twice-yearly monetary stability report. “However, this episode confirmed as soon as once more how excessive leverage can amplify hostile shocks.”
The Fed stated measures of leverage averaged throughout hedge funds within the first quarter of 2024 have been at or close to the very best stage since 2013, when it started monitoring the quantity of debt utilized by the funds.
The central financial institution stated sparse market liquidity, particularly throughout occasions of stress, might additionally amplify volatility and exacerbate the fallout.
Regardless of its warnings about indebted hedge funds, the Fed was sanguine about general dangers within the monetary system, saying that generally banks “remained sound and resilient”.
Most home banks, the Fed’s report stated, had excessive ranges of liquid belongings, and their reliance on uninsured deposits, a set off for the regional banking turmoil final yr, had decreased.
The Fed’s report, which mirrored information and knowledge obtainable by November 4, confirmed that its contacts on Wall Road have been involved concerning the sustainability of the US debt burden, particularly if the Treasury division needed to maintain issuing extra authorities bonds to pay for it.
The Fed warned that this dynamic might put “upward strain on long-term rates of interest that would additional damp progress and pressure sovereign and private-sector debtors”.
Fears about inflation and in flip greater for longer rates of interest have been additionally supplanted by considerations stemming from amplified geopolitical tensions, which the Fed stated might result in a “sudden pullback from risk-taking”.
“These developments might result in declines in asset costs and losses for uncovered companies and traders, together with these within the US,” the Fed added.
