Janet Yellen of the SF Fed on Risks in the Markets

Summary articles can be found in Bloomberg and CNNMoney (I am sure others as well) and the speeech can be found at FRBSF.

Federal Reserve Bank of San Francisco President Janet Yellen said the recent increase in long-term bond yields hasn't altered the so-called ``conundrum'' of low rates compared with rates on shorter-maturity debt. . . . . ``Long-term rates have risen in recent weeks, but not by nearly enough to resolve what former Fed Chairman Alan Greenspan coined, `the bond rate conundrum,''

After years of failing to move in tandem with rates set by central banks, U.S. and European yields have surged to their highest levels since 2002. The yield on the U.S. 10-year note has climbed 52 basis points in the past month and rose to 5.32 percent on June 13.

While low risk spreads ``may well reflect an environment wherein risk genuinely is reduced,'' Yellen said she's concerned that investors are underestimating risk (my emphasis), given recent losses in subprime mortgages, soaring inflows into hedge funds and the leveraged-buyout boom.

``The possibility of a sudden reversal in risk perceptions cannot be ruled out,'' Yellen said in prepared remarks. While the global financial system has probably strengthened since the Asian crisis of 1997-98, Yellen recalled the ``sharp asset-price declines and a frightening and sudden erosion of market liquidity'' in that instance.

Asset Markets

The Fed and other central banks should rely on supervisory and regulatory tools to make sure financial institutions manage risks well, Yellen said. She agreed with the prevailing Fed view that it's best not to use interest rates to target asset prices, countering some critics who say central banks should ``dampen overly euphoric asset markets.''

``It is exceptionally difficult to distinguish `bubbles' from fundamental-based booms and monetary actions impose certain short-run costs for very uncertain future gains,'' Yellen said. ``I therefore believe that central banks should stand ready to act to cushion the economy in response to shocks when and if they occur.''

Current Account

One risk to the world economy's ``extraordinarily strong'' growth is the U.S. current-account deficit, the broadest measure of trade, which may be ``unsustainable,'' (my emphasis) Yellen said. Last year, the gap, swelled to $856.7 billion, the biggest ever, from $791.5 billion the prior year, and equaled a record 6.5 percent of GDP.

``My concern here is that a sudden unwinding of these imbalances could be associated with sharp movements in exchange rates and asset prices that could produce destabilizing economic impacts around the globe,'' Yellen said.

With delinquencies and foreclosures swallowing the subprime- mortgage market, Yellen said some lenders ``paid a high price'' for ``unduly benign'' views of risk.

In hedge funds and private-equity buyouts, Yellen said that ``some observers question whether the supposedly sophisticated investors in these funds fully understand the complexities of the investment strategies pursued by fund managers and the risks to which they are exposed.''

In addition, the so-called ``carry trade,'' in which investors borrowing currencies such as yen for a cheap rate in order to buy higher-yielding bonds abroad, ``exposes investors to substantial exchange rate risk,'' Yellen said.

Interest Rates

The Fed's Open Market Committee is likely to keep its target rate for overnight loans between banks at 5.25 percent for an eighth straight meeting when Yellen, Chairman Ben S. Bernanke and their colleagues gather June 27-28, according to economists surveyed by Bloomberg. Policy makers see inflation as the ``predominant'' economic risk.