Low interest rates are feeding a surge in excessive risk-taking in more murky corners of the finance industry and leaving markets increasingly on edge, the US Treasury said Tuesday.
With investors pushing ever-harder for better returns through increased leveraging, a new report from the Treasury's Office of Financial Research said money is increasingly flowing into areas with less oversight, raising the dangers to financial stability.
The still-unexplained, historically precipitous swing in the bond market on one day in October demonstrated the rising dangers, which are not being taken seriously by investors, according to the report.
"We see material evidence of excessive risk-taking during the extended period of low interest rates and low volatility," the OFR's annual report to Congress said.
The report said that markets are more shaky as the Federal Reserve moves closer to tightening monetary policy, with the potential outcome being a greater risk of asset fire sales and runs in short-term funding markets.
Moreover, it said, "We are concerned that financial activity is migrating toward areas of the financial system where threats are more difficult to assess because information is not available, and that activity may be consequential."
The dangers in the system remain far less than before the 2008 crisis, which plunged the country into a deep recession.
"Compared with the period just before the financial crisis, threats to financial stability are moderate. But that relatively benign backdrop is no cause for complacency," said OFR director Richard Berner.
But the OFR report expressed concerns that investors generally are taking for granted low interest rates and high market liquidity, two hallmarks of the Fed's post-crisis easy-money policy.
"Investors may have become too sanguine about the availability of market liquidity -- the ability to transact in size without having a significant impact on price -- during both good times and bad," it said.
It pointed to an abrupt, historically sharp move in the Treasury bond trade in October, still unexplained, that stirred fears into markets.
"The liquidity strains in the US Treasury market spread quickly to other markets, affecting related asset classes such as interest rate futures, swaps, and options to differing degrees," it said.
"We believe there is a risk of a repeat occurrence, given the increased prevalence of algorithmic trading, a shift in risk preferences by broker-dealers, and the persistent incentives for risk-taking."
A particular area of concern, the Treasury said, is the surge in leverage loans and collateralized loan obligations -- loan-based securities -- which are now much higher than just before the financial crisis.
On the other hand, compared to the crisis, the risk of a contagion spreading through the financial system, damaging major banks, has fallen sharply after measures to tighten regulation, the report said.
"Conservative balance sheets have made banks more resilient to financial shocks."