“With investors ebullient on expectations for a strong rebound, it is important to closely monitor risks to the system and ensure the financial system is resilient,” Fed Governor Lael Brainard said in a statement released alongside the U.S. central bank’s semi-annual report, which reiterated some longstanding concerns and highlighted new ones.
Commercial real estate remains potentially vulnerable, the Fed said, particularly after a pandemic that may dim demand for office space, and businesses and households “remain under considerable strain” due to the impact of the virus.
Of emerging concern: the possibility of a quick reversal in recent stock market gains, the proven ability of social media to drive up stock prices and just as quickly drive them down, and the worrying implications for risk management when Archegos Capital Management, a family office, failed and led to losses at several large banks.
The Fed also called out the need for “structural fixes” in money market funds that faced a run of redemptions at the start of the pandemic and had to be included in central bank emergency lending programs.
“Vulnerabilities associated with liquidity transformation at these funds remain prominent,” the Fed concluded, referring to the fact that the funds offer investors the ability to cash out faster than the underlying assets of the fund can be sold.
Given the events of the last year, the situation is in many ways better than feared a year ago. Mortgage defaults by homeowners, for example, are below pre-pandemic levels because of the fiscal support rolled out for families; business debt overall is high but strong earnings, low rates, and government support “have increased the ability of businesses to service these obligations.”
Banks “remain well capitalized.”
Still, the report laid out a litany of potential near-term risks to the financial system should the pandemic take a turn for the worse and derail the U.S. recovery.
Asset prices could fall, particularly imperiling highly leveraged life insurance companies and hedge funds; money market funds could see runs; and financial market stress could interact with potential risks from new digital payments systems, the report said.
If Europe cannot contain the virus and government programs are not supportive enough to offset the negative effects, some important European financial institutions could incur “notable credit losses,” and in turn affect the U.S. economy and financial system, the report warned. Strains in emerging markets could also spill over to the United States.
U.S. stock indexes are at or near record highs, with the benchmark Standard & Poor’s 500 index having risen more than 11% so far this year. It is about 18% higher than when the Fed released its last financial stability report in November and has nearly doubled from its low point just over a year ago when the pandemic sparked a market panic and tumbled the United States into recession.
Corporate profits have recovered broadly this year, but equity price appreciation has outpaced the improving earnings outlook. That has pushed price-to-earnings ratios, a key valuation metric, to elevated levels and raised concerns among policymakers about “reach-for-yield” behaviors among investors and traders.
Equities are not the only part of the market exhibiting froth. Risk premiums in corporate bond markets for low-rated issuers are back to levels from before the crisis.
In its November report, the Fed warned the United States may still face a wave of debt defaults and “significant declines” in asset prices because of the pandemic and recession. So far, that has not proven the case.