Fed warns of possible ‘significant declines’ in stocks as valuations rise

People walk past the Federal Reserve building in Washington DC, the United States, on May 21, 2020.

Ting Shen | Xinhua via Getty Images

Rising asset prices in the stock markets and elsewhere pose a growing threat to the financial system, the Federal Reserve warned in a report on Thursday.

In its semi-annual financial stability report, the central bank said that while the system has remained largely stable overall despite the Covid-19 pandemic, future threats increase, especially as the aggressive share price subsides.

Investors have bought stocks, corporate bonds, and cryptocurrencies. They’ve put billions in blank check companies called SPACs, and the market for traditional IPOs has been buoyant for the most part.

Fed Chairman Jerome Powell and others have been asked repeatedly if they are concerned about rising prices. Powell has specifically stated that as long as interest rates remain low, the valuations are warranted.

However, the report notes that the danger lurks when market sentiment changes.

“High asset prices reflect in part the persistently low levels of government bond yields. However, valuations of some assets are elevated from historical norms even when measures are applied that take government bond yields into account,” the report said. “In this environment, asset prices can be vulnerable to significant declines should appetite decline.”

In an accompanying statement, Fed Governor Lael Brainard said the situation needs to be monitored and points out the importance of ensuring the system is in place with adequate safeguards. She specifically mentioned that banks should increase their capital requirements during economic expansion to cushion downturns.

The report also mentions the risk posed by hedge funds and other non-bank financial institutions as a potential threat to the system on several occasions.

“The security gaps associated with an increased risk appetite are increasing. Valuations in a number of asset classes have risen further from the values ​​already increased at the end of last year,” said Brainard. “The
The combination of stretched valuations and very high corporate debt is seen as the impact of a revaluation event can be amplified. “

The report notes that certain sectors, including energy, travel and hospitality, are particularly vulnerable due to their sensitivity to the pandemic. The Fed is also talking about potential threats from money market and open-ended funds.

The Fed elaborates on a few specific scenarios that highlight potential risks to the system. It was specifically about the Archegos Capital Management episode where the company failed to meet margin calls, causing several large banks to take huge losses.

“While broader market spillovers appeared limited, the episode shows the potential for material hardship [nonbank financial institutions] affecting the broader financial system, “the report said.

Overall, the Fed said the current state of the system is solid, budget balance sheets are in good shape, and businesses are supported by an improving economy and low interest rates that have allowed default rates to decline.

Even the $ 1.7 trillion in student loans pose “limited” risks to the economy, as most educational debt is held by the top 40% of the workforce.

A Fed survey of 24 market contacts found that virus-related concerns were the top priority, with a particular focus on vaccine-resistant variants. This is followed by a sharp rise in interest rates, a rise in inflation and tensions between the US and China.

Become a smarter investor with CNBC Pro.
Get stock picks, analyst calls, exclusive interviews and access to CNBC TV.
Sign up today to start a free trial.

Comments are closed.