Why U.S. Financial Markets Are Stable Despite High Fed Rates

More than two years into the Federal Reserve's most aggressive rate hikes in decades, the U.S. financial markets are surprisingly stable. Despite interest rates reaching 23-year highs, which have caused some localized issues, the economy has managed to avoid the widespread problems that have disrupted previous economic expansions. The Fed has kept the policy rate at 5.25% to 5.5% for about a year and is expected to maintain this rate at their upcoming meeting.

With steady economic data, investors have adjusted their expectations, now predicting only one or two rate cuts by the end of the year. Financial markets are handling the restrictive policies well. The three regional bank failures in the spring of 2023 had minimal impact on the economy, with regulators quickly stepping in to prevent broader issues. Credit spreads remain tight even among riskier bonds, and market volatility is low.

Here are three reasons why the current policies may be having less of an impact than expected:

1. Risk Moved to Private Markets

In past economic downturns, problems in public markets often led to widespread panic. For instance, the tech stock crash in 2000 and the subprime mortgage crisis in 2007 were highly visible and caused broad market contagion. Today, a significant portion of financing comes from private markets rather than public ones.

Due to stricter regulations on public financial institutions, private entities like pension funds, endowments, family offices, and wealthy individuals are more involved in lending through non-bank institutions. This shift means that issues in private lending are less visible and less likely to cause widespread panic. For example, missed interest payments in private credit markets don't make headlines, which helps prevent herd behavior among investors.

Private credit is substantial, estimated at around $1.7 trillion, though the exact amount is unclear due to a lack of transparency. Pension funds and insurance companies investing in private credit are also less likely to withdraw their investments suddenly, reducing the risk of abrupt funding stops.

The Risk: While the private credit market has not caused major disruptions yet, it remains a potential risk. A recent incident involving a company moving assets to avoid lenders highlighted vulnerabilities in this sector. The International Monetary Fund (IMF) has expressed concerns about the private credit market's opacity and potential to amplify negative shocks, especially if underwriting standards decline.

2. Government Spending Fuels Growth

In past economic expansions, companies or households often took on too much debt, leading to crashes. This time, the federal government has taken on more debt to stimulate growth. Government spending significantly contributed to GDP growth in 2023, with federal debt reaching 99% of GDP in fiscal year 2024.

Government debt is considered safer than private sector debt because the government can tax its citizens, making leveraging the federal balance sheet less risky than household or corporate borrowing.

The Risk: Even governments can face financial trouble, as seen in the UK's 2022 crisis over unfunded tax cuts. Rising interest rates are increasing U.S. borrowing costs, and there are warnings about the sustainability of U.S. fiscal policy. According to Seth Carpenter, chief global economist at Morgan Stanley, there is a limit to how much debt the market can absorb without driving up yields.

3. The Fed’s Careful Balancing Act

Despite raising interest rates and reducing its bond portfolio, the Federal Reserve has been attentive to risks. For instance, when Silicon Valley Bank collapsed in March 2023, the Fed provided emergency funding to stabilize the situation while continuing its fight against inflation.

The Fed has signaled a preference for caution, even suggesting a bias towards lowering borrowing costs to avoid triggering a recession. This careful communication helps limit market volatility and generally eases financial conditions.

The Risk: The Fed cannot control every aspect of the financial system. High interest rates over an extended period can cause stress, particularly in less regulated areas. Jason Callan, head of structured asset investing at Columbia Threadneedle Investments, notes that there is significant behind-the-scenes stress. Additionally, much lending to low-income households is done by fintech firms outside traditional regulatory oversight, raising concerns about the stability of this "shadow banking" sector during economic downturns.

Karen Petrou, co-founder of Federal Financial Analytics, warns that rising inequality could lead to greater financial instability, with even minor economic or financial stress potentially turning toxic.

Conclusion

The stability of U.S. financial markets despite high Fed rates is due to a mix of private risk management, government debt-driven growth, and the Fed's careful balancing of risks. However, potential vulnerabilities remain, and ongoing vigilance is necessary to maintain economic stability.

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