Fed Issues Market Red Alert: Warns Stocks Vulnerable To "Significant Declines"

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by Tyler Durden
Monday, Nov 08, 2021 - 04:20 PM

It's not just increasingly more banks warning that the market is in a bubble and extremely elevated asset prices are risking a broader market crash (see "This Is How One Bank Will Trade The Bursting Of The Biggest Ever Asset Bubble In 2022"): moments ago, in its semi-annual Financial Stability Report, the Fed itself has issued the same warning.

In the 85-page report published moments after the market close, the Fed warned that as Bloomberg put it, "prices of risky assets keep rising, making them more susceptible to perilous crashes if the economy takes a turn for the worse" adding that “asset prices remain vulnerable to significant declines should investor risk sentiment deteriorate, progress on containing the virus disappoint, or the economic recovery stall."

The Fed's full view of the current level of vulnerabilities is as follows:

  1. Asset valuations. Prices of risky assets generally increased since the previous report, and, in some markets, prices are high compared with expected cash flows. House prices have increased rapidly since May, continuing to outstrip increases in rent. Nevertheless, despite rising housing valuations, little evidence exists of deteriorating credit standards or highly leveraged investment activity in the housing market. Asset prices remain vulnerable to significant declines should investor risk sentiment deteriorate, progress on containing the virus disappoint, or the economic recovery stall.
  2. Borrowing by businesses and households. Key measures of vulnerability from business debt, including debt-to-GDP, gross leverage, and interest coverage ratios, have largely returned to pre-pandemic levels. Business balance sheets have benefited from continued earnings growth, low interest rates, and government support. However, the rise of the Delta variant appears to have slowed improvements in the outlook for small businesses. Key measures of household vulnerability have also largely returned to pre-pandemic levels. Household balance sheets have benefited from, among other factors, extensions in borrower relief programs, federal stimulus, and high aggregate personal savings rates. Nonetheless, the expiration of government support programs and uncertainty over the course of the pandemic may still pose significant risks to households.
  3. Leverage in the financial sector. Bank profits have been strong this year, and capital ratios remained well in excess of regulatory requirements. Some challenging conditions remain due to compressed net interest margins and loans in the sectors most affected by the COVID-19 pandemic. Leverage at broker-dealers was low. Leverage continued to be high by historical standards at life insurance companies, and hedge fund leverage remained somewhat above its historical average. Issuance of collateralized loan obligations (CLOs) and asset-backed securities (ABS) has been robust.
  4. Funding risk. Domestic banks relied only modestly on short-term wholesale funding and continued to maintain sizable holdings of high-quality liquid assets (HQLA). By contrast, structural vulnerabilities persist in some types of MMFs and other cash-management vehicles as well as in bond and bank loan mutual funds. There are also funding-risk vulnerabilities in the growing stablecoin sector.

The report also detailed how near-term risks have changed since the May 2021 report based in part on the most frequently cited risks to U.S. financial stability as gathered from outreach to a wide range of market contacts. As the Fed cautions "despite recent improvements, an increase in uncertainty over the course of the pandemic might pose risks to asset markets, financial institutions, and borrowers in the United States and globally. In addition, stresses in the real estate sector in China caused in part by China’s ongoing regulatory focus on leveraged institutions, as well as a sharp tightening of global financial conditions, especially in highly indebted emerging market economies (EMEs), could pose some risks to the U.S. financial system. If realized, the effects of near-term risks could be amplified through the financial vulnerabilities identified in this report."

The Fed discussed these and other risks in the following "boxed" section addressing the most cited potential shocks over the next 12 to 18 months, where the biggest risk is "persistent (i.e., non-transitory) inflation and monetary tightening."

The central bank also said that “difficult-to-predict” volatility similar to this year’s meme-stock frenzy could become more frequent as social media increasingly influences trading.

To be sure, the Fed’s report, which is meant to highlight the most salient risks that could undermine the financial system, flagged many concerns that have appeared in previous documents, such as “structural vulnerabilities” in money market funds. The Fed said similar worries can be applied to stablecoins which the central bank now uses as a generic bogeyman to warn about broader risks associated with crypto adoption, even if it is now the case that stablecoin issuers will likely be treated - and regulated - as normal banks.

In the latest document, stablecoins were cited as being “susceptible to runs” and that any problems could be “exacerbated by a lack of transparency and governance standards regarding the assets backing” them.

Another concern prompting Fed worries is China’s real estate turmoil and its regulators’ focus on highly leveraged firms, including China Evergrande Group.

“Financial stresses in China could strain global financial markets through a deterioration of risk sentiment, pose risks to global economic growth, and affect the United States."

The full report is below (pdf link here).