The Federal Reserve warned of the financial stability risks posed by foamy stocks and debt-laden hedge fund betting in its bi-annual report on potential vulnerabilities in the system, and pointed to the surge in so-called meme stocks as a sign of risk-taking spiraling out of control .
The central bank’s financial stability report released on Thursday followed an unusual six-month period for the markets. During that period, stocks rose steadily as the US economic outlook rebounded and stories of surpluses surfaced.
Internet roundtables helped spark interest in stocks like GameStop, a cryptocurrency created as a hoax, and a little-known hedge fund melted down. These stories have made headlines, causing many – including obviously some at the Fed – to wonder if the financial system was headed for trouble.
“The security vulnerabilities associated with an increased risk appetite are increasing,” said Lael Brainard, a Fed governor, in a statement on the Fed’s release. Stock prices are high compared to earnings, and “risk-taking has risen sharply, as the” Meme Stock “episode demonstrated.”
The Fed’s new report painted a generally sunny picture with banks, consumers and businesses weathering the coronavirus shock in reasonable financial shape, and it said that some measures made risk appetite look typical.
However, the report found that some asset prices “may be susceptible to significant declines should appetite decline” and that “high volume and price volatility episodes for so-called meme stocks” are among the signs of “increased appetite for risk.” Stock markets “belong. Officials also selected hedge funds, saying the opaque investment vehicles had slightly higher than normal leverage, while warning that the data available on funds “may not capture major risks”.
The report, which took on a threatening tone at times, contrasted with the picture Fed officials, economists and investors alike have painted of the U.S. economy, which is expected to recover rapidly from the spread of coronavirus vaccines. It was emphasized that increasing consumer and business confidence can fuel risky bets and create or expand weaknesses in the financial markets.
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May 6, 2021, 11:23 a.m. ET
The Fed’s suggestion that more data be needed on hedge fund debt followed an episode in March when banks were having trouble at a large fund, Archegos Capital Management. The fund had amassed large, leveraged stock bets that went bad and cost the banks with which it had done business.
“While broader market spillovers appeared limited, the episode shows the potential for material hardship” in non-bank financial firms “to” affect the broader financial system, “the Fed said in its report. The opacity of hedge funds was also said to have raised questions during the meme stock episode: some funds that had wagered against the stocks in question suffered losses when chatboard vigilants poured into them.
The answer to both episodes, which Fed and Ms. Brainard seemed to suggest, starts with better data.
“Archegos’ event highlights the limited visibility of hedge fund exposure and is a reminder that the measures available to leverage hedge funds may not capture key risks,” said Brainard. She added that the episode “underscores the importance of more detailed, more frequent disclosures”.
And while bubbles were high on the list of concerns, the Fed believed that underlying economic risks remained that could disrupt financial markets.
The coronavirus pandemic, which is under control in the US but continues to rage across much of the world, continues to pose risks to the system.
“Despite significant advances in vaccination, the perceived risks associated with the progression of the pandemic and its impact on the US and overseas economies remain relatively high,” the report said. “A worsening global pandemic could put a strain on the financial system in emerging economies and some European countries.”