U.S. financial system vulnerable to bond market stress, Fed’s Logan says

By Michael S. Derby

NEW YORK (Reuters) -Dallas Federal Reserve President Lorie Logan said on Friday the U.S. government bond market remains vulnerable to significant shocks that could cause broader damage, adding that government authorities must push ahead with efforts to shore up the financial system.

“The U.S. financial system has become increasingly vulnerable to core market dysfunction because the supply of intermediation has not kept pace with demand as the Treasury market’s size and complexity have grown,” Logan said in the text of a speech to a University of Chicago Booth School of Business event.

She pointed to a rapid expansion of U.S. government debt and a change in who buys and trades that debt, as well as the diminished role of the large banks that once dominated the government bond market, as helping to drive up vulnerabilities to major shocks.

When trouble arrives of such a level that it could threaten the basic functioning of markets, it is appropriate for authorities to take action, as they have in the past, Logan said. She pointed to the U.S. central bank’s intervention to both borrow and then buy massive amounts of government debt at the start of the coronavirus pandemic three years ago as a key chapter in authorities’ actions to save a failing market.

Logan, who holds a vote in this year’s Federal Open Market Committee monetary policy meetings, did not comment on the outlook for monetary policy and the economy in her prepared remarks.

Before taking over as head of the Dallas Fed last year, Logan was a key official at the New York Fed designing and implementing the monetary policy directives of the FOMC. She spoke amid ongoing concern about how financial markets, most notably the sector that trades U.S. government debt, will respond to the next chapter of stress.

Those anxieties have been heightened by the aggressive Fed rate increases that are aimed at reducing high levels of inflation. Those increases in borrowing costs coupled with the central bank’s ongoing efforts to shed bonds to reduce its market footprint, have raised questions about what authorities might do to support markets in the future. A paper this week from the New York Fed said the official sector needs to move toward finding a more formalized approach to providing support.

That said, a semi-annual monetary policy report released by the Fed on Friday sounded a somewhat sanguine note on market risk at the current moment.

“Against the backdrop of a weaker economic outlook, higher interest rates, and elevated uncertainty over the second half of the year, financial vulnerabilities remain moderate overall,” the Fed said in the report, adding that, for now, the financial system remains flush with cash.

Trading in the Treasury market has been “orderly,” although that particular market was more challenged on the liquidity front compared to others, it said.

‘ENHANCE MARKET RESILIENCE’

Logan said “central banks should rarely intervene to support the functioning of core markets, but when such interventions are needed, they must be effective.” She added that interventions, such as official sector bond buying, can help in one way but cause problems on other fronts.

She said authorities are continuing to work on methods to formalize how they might intervene and to shore up underlying market strength. She said it was critical that any efforts be clearly communicated and understood, and should the Fed need to buy bonds to shore up the market, that it be clearly marked as a support operation and not for monetary policy purposes.

“The public and private sectors must work together to enhance market resilience so that these episodes will be far less frequent going forward,” Logan said. Authorities should also “be prepared for those rare occasions when extreme stresses in core markets threaten financial stability or the macroeconomy” and “central banks must continue to develop the toolkit for mitigating dysfunction,” she added.

(Reporting by Michael S. Derby; Editing by Andrea Ricci and Paul Simao)