Fed warns of peril in run-up of risky asset prices, stablecoins

WASHINGTON (BLOOMBERG) – The United States Federal Reserve is warning that prices of risky assets keep rising, making them more susceptible to perilous plunges if the economy takes a turn for the worse, and cited stablecoins as an emerging threat.

“Asset prices remain vulnerable to significant declines should investor risk sentiment deteriorate, progress on containing the virus disappoint, or the economic recovery stall,” the Fed said in its twice-yearly Financial Stability Report released on Monday (Nov 8).

The central bank also said stablecoin threats are growing, that fragility in China’s commercial real estate sector could spread to the US if it deteriorated dramatically, and that “difficult-to-predict” volatility similar to this year’s meme-stock frenzy could become more frequent as social media increasingly influences trading.

While the Fed is sounding alarms about high asset prices, some economists have said the central bank’s own policies are behind much of the surge. As Covid-19 struck the US in March last year, the Fed cut interest rates to near zero and began buying massive amounts of Treasuries and mortgage-backed securities, contributing to rallies for stocks and other investments. While equities long ago eclipsed their pre-pandemic levels, the Fed kept its emergency policies in place to help the much-slower recovery in employment.

Last week, the Fed decided to begin scaling back its monthly bond buying, putting it on a path to end the purchases in June and raise interest rates as soon as late next year. Assuming inflation trails off next year, as the Fed and Biden administration are projecting, it may be at least a few more years until the central bank’s benchmark interest rate is close to the 2.5 per cent level currently seen as normal in the long run.

The Fed’s stability report, which is meant to highlight risks that could undermine the financial system, flagged many concerns that have appeared in previous documents, such as “structural vulnerabilities” in money market funds. The Fed said similar worries can be applied to stablecoins – digital tokens pegged to fiat currencies that underpin much of the trading in Bitcoin and other crypto assets.

In the latest document, stablecoins were cited as being “susceptible to runs” and that any problems could be “exacerbated by a lack of transparency and governance standards regarding the assets backing” them. Last week, the Fed joined the Treasury Department and other agencies in urging Congress to pass legislation that would regulate stablecoins like banks with steep capital requirements and constant supervision.

Another area prompting Fed worries is China’s real estate turmoil and its regulators’ focus on highly leveraged firms, including China Evergrande Group.

“Financial stresses in China could strain global financial markets through a deterioration of risk sentiment, pose risks to global economic growth, and affect the United States,” the Fed said.

The US housing market also attracted the Fed’s attention, with the central bank noting that prices have “increased rapidly” since it issued its previous report in May. Still, the Fed said that it is not seeing the types of dangerous market practices that fueled the 2008 financial crisis.

“Even amid such rapid and widespread price growth, there is currently little indication of highly leveraged real estate investment activity or of a deterioration in underwriting standards,” the central bank said.

The report included a survey of 26 market contacts – consisting of brokerages, investment funds, political advisory firms and other companies – on what they consider to be the top threats to financial stability. As their top concerns, the firms cited persistent inflation, vaccine-resistant Covid-19 variants, China regulatory and real estate risks, US relations with China and cryptocurrencies.

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