Risky business: The Fed, and Elon Musk, sound the alarm bells on financial markets – Sydney Morning Herald

Fed governor Lael Brainard, in a statement released with the report, referred to an elevated appetite for risk, citing the meme stock episode presumably a reference to the GameStop debacle as an example.

It isnt only equity markets where prices are near the top of their historical distribution, with Brainard saying corporate bond markets were also seeing elevated risk appetite and that the spreads of lower-quality speculative-grade bonds relative to Treasury yields were among the tightest the Fed had seen historically.

She said the failure of Archegos Capital Management the family office that blew up earlier this year, showering billions of losses on some of the worlds largest banks highlighted the potential for non-bank institutions like hedge funds and other leveraged investors to generate large losses within the financial system.

The Archegos event illustrates the limited visibility into hedge fund exposures and serves as a reminder that available measures of hedge fund leverage may not be capturing important risks.

The potential for material distress at hedge funds to affect broader financial conditions underscores the importance of more granular, higher-frequency disclosures, she said.

In the aftermath of the 2008 financial crisis regulation of banks was tightened substantially. A side-effect was to drive a significant amount of activity, particularly higher-risk activity, into the shadows of the financial system inhabited by less-regulated and less-visible entities like hedge funds, private equity and other non-bank institutions.

If markets are in bubble territory because of ultra-low rates, then any meaningful increase in inflation and consequent rise in real interest rates could burst them and, given how stretched valuations in most financial markets are and the levels of speculative activity in cryptocurrencies and meme stocks, cause chaos in financial markets.

As part of its information-gathering, the Fed conducts surveys of market participants and other parties, asking them for their view on risks to financial stability.

In the previous survey, conducted last September/October, the biggest perceived risk was political uncertainty, followed by corporate and small business defaults, insufficient fiscal stimulus and a resurgence of the pandemic. Stretched asset valuations came in at number five.

In the lead-up to the US elections and with the pandemic still raging, that ordering of risks was understandable.

The latest survey has vaccine-resistant strains of the virus at the top of the list of risks, followed by a sharp rise in interest rates, a surge in inflation, US-China tensions and risky asset valuations.

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A lot can change in six months and it isnt surprising that the combination of a spike in interest rates and inflation and their implications for riskier assets were elevated within the list of risks to financial stability.

If markets are in bubble territory because of ultra-low rates, then any meaningful increase in inflation and consequent rise in real interest rates could burst them and, given how stretched valuations in most financial markets are and the levels of speculative activity in cryptocurrencies and meme stocks, cause chaos in financial markets.

Low interest rates have also driven a surge in high-yield and unrated corporate debt (junk bonds). Last year the market for that high-yield debt in the US grew 25 per cent, or more than 3.5 times its historical average annual growth rate.

Spreads on those loans, and on leveraged loans, were very narrow relative to historical levels. A graphic in the Fed report shows that the excess bond premium the component of corporate bond yields not explained by risk-free rates or default risks is negative and among the lowest recorded for decades, which the Fed says (in its understated way) indicates a high risk appetite.

Federal Reserve board member Lael Brainard referred to an elevated appetite for risk in markets today.Credit:Bloomberg

So, equity market valuations are, by historical standards, stretched. There is increased speculative activity in meme stocks and cryptocurrencies. Increased initial public offerings, (especially listings of special purpose acquisition vehicles) also point to increased appetites for risk, as do spreads in corporate debt markets.

Leverage in banks is low but leverage in hedge funds is high and issuance of collateralised loan obligations the corporate debt equivalent of the collateralised debt obligations that nearly blew up the global financial system in 2008 is at record levels so far this year.

If you were grading risk factors for the global financial system now the pandemic would probably still remain at the top of the list but the longer negligible interest rates drive rising equity markets and tightening spreads on higher-risk corporate debt the greater the risk that any external shock creates a self-fuelling scramble by investors to dump their exposures.

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A surge in inflation expectations and interest rates is the obvious risk (albeit not the only one) of a shock that could trigger market implosions and another bout of severe market turbulence, financial instability and another crisis if the stretched valuations and high levels of riskier corporate indebtedness arent unwound before any threat emerges.

It is hard to see how that could happen unless the world experiences the rare combination of very strong economic without any material accompanying inflation.

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Risky business: The Fed, and Elon Musk, sound the alarm bells on financial markets - Sydney Morning Herald