This is a pretty serious warning from Fed Governor Lael Brainard:
The latest Financial Stability Report provides valuable analysis to track increases in financial system vulnerabilities. I would highlight a few areas. Vulnerabilities associated with elevated risk appetite are rising. Valuations across a range of asset classes have continued to rise from levels that were already elevated late last year. Equity indices are setting new highs, equity prices relative to forecasts of earnings are near the top of their historical distribution, and the appetite for risk has increased broadly, as the “meme stock” episode demonstrated. Corporate bond markets are also seeing elevated risk appetite, and the spreads of lower quality speculative-grade bonds relative to Treasury yields are among the tightest we have seen historically. The combination of stretched valuations with very high levels of corporate indebtedness bear watching because of the potential to amplify the effects of a re-pricing event.
Basically he’s saying things are getting pretty ridiculous out there in the markets. And by “re-pricing event” he means a market crash.
The FSR describes the failure of Archegos Capital Management and the associated losses at a number of large banks. It highlights the potential for nonbank financial institutions such as hedge funds and other leveraged investors to generate large losses in 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.
In other words, nobody has any idea just how leveraged up these hedge funds are and how bad it will be when they start blowing up. They’re all opaque.
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. With valuations and risk appetite at elevated levels, strong microprudential safeguards and macroprudential tools such as the Countercyclical Capital Buffer will be important to address risks to financial stability and enable monetary policy to focus on its maximum employment and average inflation goals.
Investors are “ebullient,” which is another word for EXUBERANT, an emotion that typically marks the top of a bubble.
What is a “Countercylical Capital Buffer”? I’ve never heard that term before. At the St. Louis Fed’s website, they describe it thusly:
A countercyclical capital buffer is a type of capital buffer that regulators might impose on banks. The first word, “countercyclical,” adds a “when” element to the term.
A countercyclical capital buffer would raise banks’ capital requirements during economic expansions, with banks required to maintain a higher capital-to-asset ratio when the economy is performing well and loan volumes are growing rapidly. Conversely, it would require a lower capital-to-asset ratio during recessions, as the Cleveland Fed explained in a 2018 Economic Commentary article.
Based on both Brainard’s remarks and that quote above, it doesn’t sound like the CCCB is something the Fed is currently mandating. Brainard says the CCCB will be important to address risks, not that it is currently in place.
I don’t know much about the CCCB, but it sounds like something that would decrease the amount of lending a bank does, which to me seems like a “back-door” way to raise interest rates without actually raising interest rates. When you raise interest rates, lending slows, right? The CCCB also seems like something that would slow the pace of lending, at least to me. Different policies, same outcome.
It seems like the Fed might be about to slam the brakes on this whole stock market bonanza that’s happening right now. The Fed is now openly discussing the fact that things are completely out of control, and at least one Governor on the Fed does not like what he sees.
But then again, does anyone really believe there’s a chance the market goes down ever again? At this point it feels like even a 5% pullback is impossible. The Dow hasn’t dropped 5% in over 6 months. Flat is the new down.
I mean, obviously this is going to end badly at some point in time, but who the hell wants to bet against this market right now? It’s like trying to stop a runaway freight train by standing on the tracks and yelling “stop!”