On the eve of Waller's appointment, the Federal Reserve suddenly sounds the alarm! Are the "three major risks" in the financial markets approaching?

As Walsh is about to officially assume the role of Federal Reserve Chairman, concerns over financial market risks within the Fed are intensifying. The latest released meeting minutes show that Fed staff and several policymakers are increasingly worried about elevated asset valuations, rising bond yields, lack of transparency in private credit, and potential shocks to the financial system from AI-related debt financing.

The Fed Considers Financial System Vulnerabilities to Remain Significant

The minutes of the Federal Open Market Committee meeting held on April 28-29 indicate that Fed staff overall continue to believe that vulnerabilities in the financial system remain significant.

The minutes point out that Fed staff judged that pressures from high asset valuations persist. Although personnel remain relatively calm about household balance sheets, they expressed concerns over certain lending activities, especially the borrowing activities of hedge funds active in the U.S. Treasury market.

At the same time, some policymakers also voiced similar concerns. The minutes reveal that several participants noted that asset valuations remain high, increasing the likelihood of sharp corrections in the face of adverse events.

In addition, many officials expressed concern over the private credit market due to its lack of transparency and the difficulty for outsiders to fully identify risk exposures.

Strong Market Performance Diverges from Economic Fundamentals

Despite a more gloomy economic outlook caused by the Middle East war, the U.S. stock market continues to post strong gains, making it difficult for some Fed officials to reconcile market performance with economic fundamentals.

Meanwhile, global bond market yields have surged, with investors increasingly worried about inflationary pressures and government financing prospects. As long-term rates rise, equity valuations, credit markets, and corporate financing costs all face repricing pressures.

Another growing area of concern is the reliance on debt financing for Artificial Intelligence investment. As tech companies and related infrastructure projects continue to ramp up AI investment, the market is starting to worry that if returns from AI-related projects fall short of expectations, the associated debt could become a new source of financial stress.

Walsh’s Appointment May Change How the Fed Intervenes in Markets

This meeting was held on the eve of a leadership transition at the Fed. Kevin Walsh will be sworn in as Federal Reserve Chairman on Friday, succeeding Jerome Powell. Powell will continue to serve as a Fed governor for a period of time.

Walsh has previously criticized some of the core policy tools adopted by the Fed in recent years, especially the use of large-scale asset purchases to stabilize markets and the reinforcement of short-term rate targets.

He also favors strengthened coordination between the Fed and the Treasury Department in matters beyond monetary policy. This means, under Walsh’s leadership, there may be some changes in how the Fed uses various liquidity tools to respond to financial stress.

Some market participants worry that under Walsh’s leadership, the Fed may be less willing than before to intervene rapidly in times of market turmoil. At the same time, if Walsh advances the reduction of the Fed’s balance sheet, this could further increase risks in the financial system to some extent.

The Fed Discusses Improvements to Multiple Liquidity Tools

The minutes show that some Fed officials discussed existing and potential operational improvements related to multiple liquidity tools. These include the discount window, standing repo facility, and swap arrangements for providing dollar liquidity to other major central banks.

The minutes also indicate that when officials voted to confirm the current monetary swap arrangements, a minority expressed interest in extending them beyond this year. They believe that longer-term arrangements would help promote financial stability.

The Fed has long encouraged more deposit-absorbing banks to prepare for use of the discount window. The discount window is the Fed’s traditional tool for rapidly providing credit to banks, but due to longstanding stigma issues, many banks are reluctant to use it proactively during times of stress.

Meanwhile, the Fed has also been adjusting repo operation arrangements. The repo tool can provide cash to eligible financial institutions, and demand typically rises during periods of tight market liquidity due to seasonal or calendar factors.

The Fed’s Toolkit Faces Future Tests

The Fed’s liquidity tools are designed to stabilize markets and ensure the central bank’s ability to firmly control its rate targets during periods of stress. Over the past few years, these tools have been tested during the Covid-19 pandemic and the banking sector crisis in the spring of 2023.

Roberto Perli, manager of the New York Fed’s System Open Market Account, said this week that the current system “has proven to be highly effective.”

However, there remains uncertainty about how Walsh will view this toolkit in the future.

Many observers and current central bank officials believe the Fed’s current array of tools has formed a complex web of interconnections. Gradually dismantling this system, or returning to the pre-crisis operational framework of nearly twenty years ago, would be extremely difficult and take a long time to accomplish.

Financial Stability Will Be Walsh’s First Major Test After Taking Office

Overall, as Walsh takes over the Fed, financial markets are in a highly sensitive phase.

On one hand, U.S. stocks continue to climb amid the AI boom, with asset valuations remaining high. On the other hand, global bond yields keep rising, inflation and fiscal financing pressures are intensifying, and private credit and AI debt financing are emerging as new risk focal points.

This means that after taking office, Walsh will not only need to deal with inflation and interest rate policy issues, but will also immediately face a host of complex challenges, such as how to maintain financial stability, how to utilize Fed liquidity tools, and how to manage the size of the Fed’s balance sheet.