COVID-19 remains a near-term financial risk – Fed report

Although progress has been made in recent months with vaccinations, the near-term risks associated with the COVID-19 pandemic remain relatively high, the Federal Reserve said in its semiannual Financial Stability Report released Thursday.

Outside the U.S., the pandemic's worsening could stress the financial system in emerging markets and some European countries, according to the central bank.

Also, asset prices "may be vulnerable to significant declines should investor risk appetite fall, progress on containing the virus disappoint, or the recovery stall," the Fed said. "Some segments of the economy — such as energy, travel, and hospitality — are particularly sensitive to pandemic-related developments."

Valuations in a range of asset classes have continued to rise from levels that were already elevated late last year, said Lael Brainard, a member of the Federal Reserve's board of governors, in a statement. "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," she said.

"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," Ms. Brainard added in the statement. "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 Fed also noted some positive developments over the six months since its last report, including that banks remain well capitalized, and leverage at broker-dealers is low. However, the Fed caveated its point on bank capitalization to note that banks may face heightened credit risk in the sectors most affected by the COVID-19 pandemic, like energy and hospitality.

Moreover, vulnerabilities from both business and household debt have declined, reflecting a "slower pace of business borrowing and an improvement in earnings as well as government programs that have supported business and household incomes," the central bank said.

Since the outset of the pandemic in March 2020, the Fed has held its benchmark interest rate near zero and is purchasing bonds — currently $120 billion a month split between $80 billion in Treasury securities and $40 billion of mortgage-backed debt.

In February, while testifying before Congress, Fed Chairman Jerome Powell said the central bank's bond purchases, and the "associated increase in the Federal Reserve's balance sheet, have materially eased financial conditions and are providing substantial support to the economy."