With ‘appetite for risk’ on the rise, stretched valuations bear watching, Fed leader warns

The “appetite for risk” has increased broadly over the last year, largely because of “stretched valuations” of assets – which, together with high levels of corporate indebtedness bear watching because of the potential to amplify the effects of a re-pricing event, a member of the Federal Reserve Board said in a statement Thursday accompanying the agency’s latest “Financial Stability Report” (FSR).

In her statement, Gov. Lael Brainard highlighted some key areas of the report, which is released semi-annually by the central bank. Among those 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 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.

“The FSR describes the failure of Archegos Capital Management and the associated losses at a number of large banks,” Brainard said. “It highlights the potential for nonbank financial institutions such as hedge funds and other leveraged investors to generate large losses in the financial system.”

She said the Archegos event (a forced liquidation in March of positions – primarily in swaps — held by the firm Archegos Capital Management that resulted in instability for a number of firms, including banks) “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.”

She added that the potential for material distress at hedge funds to affect broader financial conditions “underscores the importance of more granular, higher-frequency disclosures.”

Financial Stability Report: Statement by Gov. Lael Brainard

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