By Paul Kiernan
WASHINGTON -- The Covid-19 pandemic remains one of the biggest
near-term risks to the stability of the financial system, the
Federal Reserve said, while noting that asset prices are vulnerable
to significant declines if investor sentiment shifts.
"Should risk appetite decline from elevated levels, a range of
asset prices could be vulnerable to large and sudden declines,
which can lead to broader stress to the financial system," the
central bank said in its semiannual Financial Stability Report.
Such scenarios could materialize if progress on containing the
virus falls short of expectations or the recovery stalls, straining
some households and firms, the Fed said.
The report said other parts of the financial system appear
resilient. Banks remain well capitalized, it said, and leverage is
low among broker-dealers. Household debt is manageable, and
businesses are better able to service their obligations as interest
rates remain low and earnings improve, it said.
High asset valuations were also flagged in the previous
financial stability report, released in November. Thursday's report
showed measures of risk-taking have continued to rise in equity and
bond markets since then. It also noted pockets of opaque risk and
high leverage, particularly among hedge funds and related
entities.
Fed Chairman Jerome Powell has described parts of the market,
including equities, as "a bit frothy."
"The overall financial-stability picture is mixed," Mr. Powell
said last week. "But on balance, you know, it's manageable, I would
say, and...it's appropriate and important for financial conditions
to remain accommodative, to support economic activity."
Wall Street strategists and some investors argue that elevated
stock valuations aren't a problem as long as interest rates remain
low and companies continue to report strong profit growth. But
bullish investor sentiment has also played a role in keeping stocks
moving higher, and a sudden change in their outlook would leave the
market dangerously exposed to a pullback, said Mike Bailey,
director of research at FBB Capital Partners.
Economists and Fed officials say the central bank's efforts to
boost the economic recovery have contributed to the run-up in asset
prices.
The Fed has kept its key interest rate near zero since March
2020, making it cheaper for businesses and households to borrow and
spend on things such as machinery, cars and homes. It also buys
$120 billion worth of Treasury and mortgage backed securities each
month, which holds down long-term interest rates and encourages
investors to shift money into riskier assets such as stocks and
corporate debt.
Mickey Levy, an economist at Berenberg Capital Markets LLC, said
the Fed knows its policies have unintended effects such as
"distorting financial decisions, supporting high stock prices,
accentuating wealth inequality and raising the risks of financial
instability."
"But the Fed perceives the near-term gains to employment exceed
these costs and risks," Mr. Levy said in a note to clients
Wednesday.
Thursday's report pointed to so-called "meme stocks" and the
boom in initial public offerings supported by special-purpose
acquisition companies, or SPACs, as evidence that investors'
appetite for risk "is elevated relative to history." It also noted
that yields on lower-rated corporate bonds have "declined
significantly" over the past six months even as Treasury yields
rose, indicating investors are accepting lower returns to take on
risk.
Fed officials monitor asset prices to gauge risks that a sudden,
sharp decline might pose to the broader financial system. In the
2008 crisis, the collapse of residential property values caused
overextended homeowners to default on their mortgages, inflicting
losses on banks and other financial firms, driving share prices
lower and leading to the longest and deepest recession since the
1930s.
Last year's downturn early in the Covid-19 pandemic was
different. The longest economic expansion on record had put the
average American household in relatively strong financial shape,
and banks were well-capitalized as a result of regulations enacted
after the 2008 crisis. As economic activity collapsed in March
2020, the government used its borrowing capacity to step in with
trillions of dollars in aid to households and businesses.
"A decline in asset prices, home prices, cryptocurrency -- would
certainly hurt the people holding them," said Donald Kohn, a former
Fed governor. "But it's not going to get amplified through weakness
in banks and investment banks the way it did in 2007-2008."
That doesn't mean other sectors of the financial system, such as
hedge funds, money-market funds and mutual funds that hold illiquid
corporate bonds, are well positioned to weather a decline in asset
prices, Mr. Kohn noted.
Thursday's report also said the collapse of Archegos Capital
Management, which caused more than $10 billion of unexpected losses
at major banks, highlights "the need for greater transparency at
hedge funds and other leveraged financial entities that can
transmit stress to the financial system."
While the Fed sees promoting a stable financial system as one of
its key functions, it has few tools to prevent excessive
risk-taking by investors aside from monetary policy -- a blunt
instrument that also affects workers, consumers and businesses.
So far, most Fed officials say they don't believe lofty asset
prices call for a reduction in the central bank's asset purchases,
let alone higher interest rates. One exception is Dallas Fed
President Robert Kaplan, who said Thursday that the Fed should
begin that debate as soon as it can.
"In light of some of the excesses and imbalances that can be
created by these purchases, I think it's wise and I think we would
be well served to be talking about this subject sooner rather than
later," Mr. Kaplan said in a virtual event.
Michael Wursthorn contributed to this article.
Write to Paul Kiernan at paul.kiernan@wsj.com
(END) Dow Jones Newswires
May 06, 2021 17:36 ET (21:36 GMT)
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