On November 22, the Federal Reserve released its semi-annual Financial Stability Report. According to the report, from the end of August to the end of October, the staff of the New York Fed surveyed people from broker-dealers, funds and consulting firms and other institutions and academia, and found that 54% of respondents, that is, more than half of the professionals, believe that the sustainability of US government debt in the next 12 to 18 months is a prominent financial stability risk, accounting for the highest proportion of the main risks surveyed.

By contrast, in this year's Financial Stability Report released by the Federal Reserve in April, a survey conducted between late January and late March showed that only 40% of respondents believed that debt sustainability was a prominent risk in the next year to a year and a half. In other words, after six months, the proportion of professionals who are most concerned about the threat of government debt to financial stability has increased by 14 percentage points.

Concerns about high inflation have dropped significantly, with the proportion of respondents citing persistent inflation and monetary tightening as prominent risks falling to 33%, more than half of the 72% seen in the previous survey.

Federal Reserve warns: U.S. government debt sustainability becomes the biggest financial stability risk

In its latest semi-annual Financial Stability Report, the Federal Reserve warned that the sustainability of U.S. government debt is now seen as the biggest risk to financial stability. The report is based on a survey conducted by the New York Fed between the end of August and the end of October this year, which included institutions and academics such as broker-dealers, funds and consulting firms.

According to the survey results, concerns about the sustainability of the US fiscal debt are the main risk. Fifty-four percent of respondents believe that the sustainability of U.S. government debt will be a prominent financial stability risk over the next 12 to 18 months, up from 40 percent in the April report. This risk has led to a sell-off in the US bond market, with the US 10-year Treasury yield rising sharply over the past two months, despite the fact that the Fed has cut interest rates twice in a row, accumulating 75 basis points.

In addition, the term premium of U.S. Treasuries, a measure of how much investors need to compensate for holding longer-dated Treasuries rather than shorter-term Treasuries, is near its highest level since 2010, and bond and interest rate volatility measures are higher than historical norms.

In addition to concerns about the sustainability of U.S. fiscal debt, the survey also showed heightened concerns about geopolitical tensions, recession and global trade wars in the Middle East. The proportion of respondents who believe that a recession is a prominent risk has risen to 38% from 28% last time, ranking fourth. Concerns about high inflation have dropped significantly, with the share of respondents citing persistent inflation and monetary tightening as prominent risks falling to 33% from 72% last time.

The situation in the Middle East and global trade risks pose a threat to financial stability

In its latest semi-annual financial stability report, the Federal Reserve pointed out that tensions in the Middle East and global trade risks are important threats to financial stability at present.

Tensions in the Middle East

Interviewees noted that the most immediate risk posed by tensions in the Middle East is the expansion of conflicts in the region. Some respondents stressed that tensions in the Middle East could turn into a global conflict, which is a tail risk. The main impact of the situation in the Middle East on financial stability comes from disruptions in energy supplies, as well as the potential impact on broader commodity markets.

Inflation and monetary policy

While the impact of rising inflation and Fed tightening remains the most cited risks, fewer were mentioned in this survey than last time. Respondents who continue to list inflation as a risk believe that while the data shows an improvement in inflation, it may take longer than expected to return to levels consistent with the Fed's dual mandate.

Global trade risk

Global trade risk has been mentioned several times in this report, but it was not included in the list of major risks in the previous report. In this survey, less than 35% of respondents believe that global trade risks are prominent, which is the same as the proportion of people who are concerned about inflation risks, and ranks second to the risk of a recession in the United States.

In particular, the report mentions that the risks to global trade are of concern to respondents. Some respondents noted that tariff barriers could trigger retaliatory protectionist policies, which could negatively impact global trade flows and re-introduce upward pressure on inflation. Others argued that a deterioration in global trade could dampen economic activity and increase the risk of a downturn.

Hedge fund leverage is at an all-time high

According to data collected by the U.S. Securities and Exchange Commission (SEC) PF form, leverage ratios of all types of hedge funds have reached or are close to their highest levels since data became available in 2013. Compared to the Financial Stability Report in April, both on-balance sheet leverage and the average total leverage ratio of hedge funds increased during the reporting period. In the first quarter of this year, the leverage of large hedge funds, ranked 15th to 50th, rose significantly, to about 10 times, the highest level since 2013.

The report notes that hedge funds' high leverage is partly due to increased basis trading activity in U.S. Treasury spot futures. The volatility spike in early August did not lead to a significant unwinding of basis trades, but rather had to do with some highly leveraged hedge funds having to quickly reduce the leverage on other positions.

The scale of stablecoins is growing rapidly, and the potential risks cannot be ignored

Since the last report was published in April, the size of fiat-pegged stablecoin assets has grown significantly. As of early November, the total market capitalization of stablecoins exceeded $170 billion, slightly below the record high recorded before the collapse of Terra, the sister token of the stablecoin UST, in April 2022.

Structurally, stablecoins remain vulnerable to runs, lacking a comprehensive federal prudential regulatory framework, the report argues. Although stablecoins are still relatively small in the U.S. economy, they have experienced strong growth in recent years and have the potential to scale up rapidly. Therefore, the potential risks of stablecoins cannot be ignored.