Stubborn inflation poses real risk for US' financial system

The yield on 10-year Treasury bonds of the United States closed at their highest level since 2008, while the yield on 30-year Treasury bonds rose to its highest level since 2011. The rise in yields has hit stocks and bonds, and the US financial system is at risk of instability.

With the federal funds rate surpassing 5.2 percent and uncertainty surrounding the Federal Reserve's monetary policies due to persistent inflation, banks and investors have sought refuge in US money-market assets, and stock investors have shown signs of selling for cash.

Moody's earlier downgraded the credit ratings of 10 small- and medium-size US banks, warning that the risk of deposit losses at high interest rates, a potential recession, a squeeze on bank earnings and troubled commercial real estate would worsen their asset risks. The asset liability risks for banks will worsen as the Fed continues to increase interest rates and reduce its balance sheet, leading to a decline in reserves and deposits within the banking system. The higher long-term bond yields in the US will particularly strain banks' fixed-interest assets.

Given the current signs of funding strains in the US banking sector, a mild recession early next year could lead to tighter credit conditions, deteriorating asset quality, increased likelihood of capital erosion, and rising loan losses.

While the US financial system still looks resilient, there is a genuine concern that the past decade of low interest rates following the subprime crisis has made the US overly reliant on cheap money. Unexpected interruptions in the exit strategy from near-zero interest rates, coupled with massive debt accumulation by both US companies and the government, pose risks to the financial system. With employment, housing, and other factors affecting inflation still strong, the US' inflation will remain high.

Right now, the worry is that the US' stocks and real estate are overvalued and at risk of a price crash if the financial markets wobble. It can be seen that the stubborn inflation in the US means interest rates will remain high for a long time, causing a shock to the financial system that has been dependent on low interest rates for a long time. Bubbles in real estate and stock markets have a low tolerance for the instability of the financial system, and may form a systemic financial risk.

That means the US will need to tread carefully to maintain market stability and investor confidence. But this balancing act is difficult to sustain, especially with inflation not expected to fully subside any time soon.