Rising asset values in the stock market and elsewhere pose rising risks to the financial system, the Federal Reserve warned in a report, released on Thursday. According to the central bank’s semiannual Financial Stability Report, although the system has remained relatively stable after the Covid-19 pandemic, potential risks are increasing, especially if the aggressive run on stock slows. Investors have flocked to stocks, corporate bonds, and cryptocurrency. They’ve pumped billions of dollars into blank-check firms known as SPACs, and the demand for traditional initial public offerings has been largely brisk.
Fed Chairman Jerome Powell and others have been regularly asked if they are worried about rising costs. Powell has expressly stated that the valuations are reasonable as long as interest rates remain strong. However, the study warns that there is a risk if investor perception shifts. “High asset prices are a reflection, in part, of the continuity of low Treasury yields. According to the report, “even by using measures that account for Treasury prices, valuations for such assets are elevated relative to historical norms.” “In this setting, asset prices will be vulnerable to significant losses if risk tolerance falls.”
In an accompanying statement, Fed Governor Lael Brainard said the situation is worth monitoring and emphasises the importance of ensuring the scheme has adequate protections. She explicitly listed increasing banks’ capital needs during economic expansions as a hedge against downturns. In several points, the study cites risk at hedge funds and other non-bank financial firms as possible risks to the scheme. “Vulnerabilities related to elevated risk appetite are becoming more prevalent.” According to Brainard, “values in a variety of asset classes have continued to climb from levels that were already elevated late last year.” “The mix of stressed valuations and extremely high levels of corporate indebtedness is worth watching because it has the ability to intensify the impact of a re-pricing event.”
According to the paper, some industries, such as oil, transport, and hospitality, are especially vulnerable due to their vulnerability to the pandemic. The Fed frequently discusses possible risks posed by money market and open-end funds. The Fed delves into a few concrete situations that demonstrate possible device threats. It explicitly mentioned the Archegos Capital Management incident, in which the company failed to reach margin calls, forcing many major banks to take large losses. According to the report, “while wider market spillovers seemed limited,” “the event highlights the potential for material distress at [nonbank financial institutions] to affect the larger financial system.”
Overall, the Fed said that the sector is in good shape, with household balance sheets in good shape and companies benefiting from an expanding economy and low interest rates, which have caused default rates to decline. And the $1.7 trillion in student loan debt poses “limited” threats to the economy, provided that the top 40% of taxpayers carry the majority of college debt. According to a Fed survey of 24 business contacts, the main concern is virus-related, with a particular emphasis on vaccine-resistant variants. This is accompanied by a dramatic rise in interest rates, a spike in inflation, and tensions between the United States and China.
