[85-page PDF] Federal Reserve’s latest semi-annual Financial Stability Report listing current risks and vulnerabilities.

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by mark000

ZH synopsis: www.zerohedge.com/markets/fed-issues-market-red-alert-warns-stocks-vulnerable-significant-declines

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:

  • 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.
  • 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.
  • 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.
  • 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.

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.”

www.federalreserve.gov/publications/files/financial-stability-report-20211108.pdf

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