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Fed says stock market boom, 'ebullient' investors warrant caution

Published 05/06/2021, 04:04 PM
Updated 05/06/2021, 06:36 PM
© Reuters. FILE PHOTO: A U.S. dollar note is seen in front of a stock graph in this November 7, 2016 picture illustration. REUTERS/Dado Ruvic/Illustration

© Reuters. FILE PHOTO: A U.S. dollar note is seen in front of a stock graph in this November 7, 2016 picture illustration. REUTERS/Dado Ruvic/Illustration

By Howard Schneider, Ann Saphir and Pete Schroeder

(Reuters) - Booming stocks, internet-driven "meme" investments and the black box of hedge fund financing pose increasing risks as the U.S. economy emerges from the coronavirus pandemic and investor appetite soars, the Federal Reserve warned on Thursday in its latest report on financial stability.

"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."

NEAR-TERM RISKS

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.

© Reuters. FILE PHOTO: A U.S. dollar note is seen in front of a stock graph in this November 7, 2016 picture illustration. REUTERS/Dado Ruvic/Illustration

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.

Latest comments

fed's word and action are contrary to each other which is making everything like a casino
fed: print money market: inflate fed: "stop inflate u idiot" fed: keeps printing more money 😂
Why did we have 15 Trillion on the books in the first place? that's a whole bunch of our tax $ being handed over to hedge funds.
Attention, please, mr. powell kindly asking market gamblers to make a little pause. Thank you.
120 Bil/mo QE makes no sense, unless you are trying to entice "investors" into use margin and pay interest on that margin while chasing the golden carrot. who's really winning here. The banks.
Need to raise rates already. Sonce when does the fed care more about their personal portfolios then the future by letting inflation run unperturbed.
You “want” interest rates to go up? You must have no loan or mortgage
They should worry about printing money then stock will be fine.
Not thefeds job to warn or encourage investors. Job is to keep inflation low as it was under Trump. Jerome has over 100 million in savings account
And it’s doing a TERRIBLE job at that
Fed wants you to heed their warnings, yet will continue to pump money into the markets and the economy. How can they maintain this at the rate in which they’re doing it?
print print print, so easy to solve the problems we have. why work ?
Fed can’t do much so empty talks Dow 50k coming next year
Title correction: Government makes rich richer yet again and then warns of market crash so they can keep injecting more taxpayer dollars into the stock market.
A correction in equity markets is now impossible. Don't taper and equity and real estate market balloons and forces up interest rates . I dont know where this boat is heading but I got off along time ago.
They are working over time to devalue the USD and increase the cost of living for the sheep to promote their socialist/communist agenda.
Jobs whisper number is over 1 million. Should send inflation and yields through the roof. Lets get this correction going. Yeehaw 🤠
...meanwhile, the Fed is printing out money like there is no tomorrow.
I know how the Fed can cool investor sentiment..
they could stop talking, that'd do wonders
Fed says, cool the market for me before I have to taper the party
Haha fed printer go brr
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