11/22/2021
“Asset prices remain vulnerable to significant declines”; What Do Other Financial Stability Reports State? Policymakers Focused on Crypto Risks
I read a bunch of Reports that you’ve likely ignored.
“Asset prices remain vulnerable to significant declines”
There were some recent headlines when the Fed issued its semi-annual Financial Stability Report. The money quote was:
Asset prices remain vulnerable to significant declines should investor risk sentiment deteriorate, progress on containing the virus disappoint, or the economic recovery stall.
I thought I’d go back through a few past Fed FSRs to parse how the language has changed. I focused very specifically on the language about equity markets, which looks like the focus of the concerns.
As background, the Fed is somewhat late to the game of producing FSRs, having issued its first FSR in Nov. 2018. For contrast, the Bank of England and the BIS began publishing a FSR back in 1996, the Treasury’s Office of Financial Research began issuing its FSR in 2012, and IMF in April 2016. Each of these takes a different approach to issues and organization, reflecting their specific mandates.
The Fed’s monitoring framework encompasses four distinct areas: asset valuation, borrowing by household and businesses, leverage in the financial sector, and funding risk. It is published semiannually.
The Fed tends to obsess over every word they issue, hence the ability to watch how the language has changed.
Going back to Nov. 2018, the Fed first wrote in its Overview section:
Asset valuations appear high relative to their historical ranges in several major markets, suggesting that investor appetite for risk is elevated.
By Nov. 2019, the Fed began to parse out their observation more finely, and to a degree justify elevated prices:
Equity prices relative to forecast earnings remain above their long-run median, and yields on corporate bonds are near historically low levels. However, measures of investor appetite for risk that take into account the low level of long-term Treasury yields are broadly in line with historical norms for equity and safer corporate bonds, while they are still somewhat elevated for high-yield bonds and leveraged loans.
The May 2020 report reflected the onset of Covid-related disruptions, and by Nov. 2020 the Fed’s language had reverted to roughly its Nov 2019 baseline:
After accounting for the low level of interest rates, however, measures of the compensation for risk are roughly in line with their historical norms.
The May 2021 report starts to exhibit concern, with the introduction of the mildly worded phrase “may be vulnerable:”
Looking ahead, asset prices may be vulnerable to significant declines should investor risk appetite fall, progress on containing the virus disappoint, or the recovery stall. Some segments of the economy—such as energy, travel, and hospitality—are particularly sensitive to pandemic‐related developments.
The Nov 2021 report ups the ante. No longer “may” asset prices be vulnerable; they now “remain” vulnerable:
Asset prices remain vulnerable to significant declines should investor risk sentiment deteriorate, progress on containing the virus disappoint, or the economic recovery stall.
The other three areas appear to be sanguine:
Borrowing: 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.
Leverage: Bank profits have been strong this year, and capital ratios remained well in excess of regulatory requirements. … 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.
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.
What Do Other Financial Stability Reports State?
So lets see what the other major FSRs state:
Office of Financial Research (Nov 2021): Near-term market risks appear contained by the supportive nature of fiscal and monetary policies, solid corporate earnings, and riskfree rates at historically low levels. Equity market valuations were at record levels and market sentiment was positive at the time of this report. Share prices in certain areas reached euphoric levels in 2021.
IMF Global Financial Stability Report (Oct 2021): a prolonged period of extremely easy financial conditions may result in overly stretched asset valuations and fuel financial vulnerabilities. A sudden repricing of risk in markets, should investors reassess the economic and policy outlook, could interact with such vulnerabilities, leading to tighter financial conditions and putting growth at risk in the medium term. … Asset valuations appear to be stretched in some market segments. Despite recent market turbulence, equity prices have risen further, on net, since the April 2021 GFSR, boosted by accommodative monetary policy and strong earnings. However, equity price misalignments (relative to fundamentals-based values) have remained elevated in most markets.
BIS Quarterly Review (Sept. 2021): Equity markets proved resilient in AEs, although perceived tail risks increased. … As a result, even though option-implied volatility remained rangebound, a common market-based indicator of tail risk – reflecting the prices of options that provide a hedge against large equity declines – spiked to an all-time high during the review period.
BofE (July 2021): Risky asset prices have continued to increase, which partly reflects an improvement in the economic outlook but it also reflects heightened risk appetite, which has supported increased asset valuations and reduced compensation for risk in some markets. The increase in risk-taking behaviour creates a vulnerability to a sharp correction in asset valuations and structural vulnerabilities in market-based finance could amplify such a correction.
Policymakers Focused on Crypto Risks
Interestingly, the Fed’s FSR, the OFR’s Annual Report, each contained comments on crypto-assets. This is clearly a sign of regulatory coordination in a way similar to the coordinated look into climate risks.
The growth in the market capitalization of crypto assets, together with their continued price volatility and increasing integration with traditional financial markets, has likely increased their overall risk to financial stability. (OFR)
At this point, none of the FSRs have identified tangible linkages to traditional financial markets; the nature of the discussions in the FSRs remain speculative and prospective, such as:
Crypto asset providers’ lack of operational or cyber resilience poses risks, and significant data gaps imperil financial integrity. Crypto assets in emerging markets may accelerate dollarization risks. (IMF)
Increased use of stablecoins to create leverage on trading platforms and in DeFi arrangements could raise the risk of fire sales and contagion to other markets following a decline in digital asset prices. (OFR)
The increase in risk-taking has also manifested in the price volatility of certain cryptoassets. …Spillovers to broader financial markets from this episode were limited. … developments could increase the interlinkages between cryptoassets and other systemic financial markets and institutions (Bank of England)