The Federal Reserve warned about financial stability risks emanating from frothy stocks and debt-laden hedge fund bets in its twice-annual report on potential vulnerabilities in the system, pointing to the rise of so-called meme stocks as one sign that risk-taking could be getting out of hand.
The central bank’s Financial Stability Report, released Thursday, followed an unusual six months for markets. Over that period, stocks climbed steadily as the U.S. economic outlook rebounded, and stories of excess began to crop up.
Internet discussion boards helped fuel interest in stocks such as GameStop, a cryptocurrency created as a joke has run up in value, and a little-known hedge fund melted down, stories that have captured headlines and caused many — including, evidently, some at the Fed — to ask whether the financial system was headed for problems.
“Vulnerabilities associated with elevated risk appetite are rising,” Lael Brainard, a Fed governor, said in a statement accompanying the Fed’s release. Stock prices are high compared with earnings, and “the appetite for risk has increased broadly, as the ‘meme stock’ episode demonstrated.”
The Fed’s new report painted a generally sunny picture in which banks, consumers and businesses have weathered the coronavirus shock in decent financial shape, and it said that by some measures, risk appetite looked typical.
But the report noted that some asset prices “may be vulnerable to significant declines should risk appetite fall” and said “episodes of high trading volumes and price volatility for so-called meme stocks” were among signs pointing to “elevated risk appetite in equity markets.” Officials also singled out hedge funds, saying the opaque investment vehicles have slightly higher-than-normal leverage while warning that available data on funds “may not capture important risks.”
The report, which at times took on an ominous tone, came in contrast to the picture that Fed officials, economists and investors alike have been painting about the U.S. economy, which is expected to undergo a rapid rebound now that coronavirus vaccines have become widely available. In doing so, it underscored that increasing consumer and business confidence could fuel risky bets and create or expand financial market vulnerabilities.
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The Fed’s suggestion that more data was needed on hedge fund debt followed an episode in March when problems at a large fund, Archegos Capital Management, spilled back to hurt banks. The fund had amassed big, leveraged stock bets that went bad and ended up costing banks it had done business with.
“While broader market spillovers appeared limited, the episode highlights the potential for material distress” at financial companies that aren’t banks “to affect the broader financial system,” the Fed said in its report. It said hedge fund opacity had also raised questions during the meme stock episode: Some funds that were betting against the stocks in question took losses as chat board vigilantes poured into them.
The answer to both episodes, the Fed and Ms. Brainard seemed to suggest, starts with better data.
“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,” Ms. Brainard said. She added that the episode “underscores the importance of more granular, higher-frequency disclosures.”
And while bubbles ranked high on the list of concerns, fundamental economic risks that could disrupt financial markets also persisted, based on the Fed’s assessment.
The coronavirus pandemic, which is coming under control in the United States but continues to rage across large portions of the world, poses continued risks to the system, it said.
“Despite substantial progress with vaccinations, perceived risks associated with the course of the pandemic and its effects on the U.S. and foreign economies remain relatively high,” the report said. “A worsening of the global pandemic could stress the financial system in emerging markets and some European countries.”