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The Fed Warns The ‘Drop In Asset Prices Might Be Particularly Large’

November 28, 2018

The stock market today is celebrating the rapid reversal in the Fed’s hawkish attitude under the tenure of Jay Powell.

Surely there are some measures that suggest the extent of the current monetary tightening campaign has already surpassed that of those of the recent past.

But if the Fed is now backing off because monetary tightening has already exerted its typical effect on the credit cycle this is certainly not bullish for risk assets.

In this vein, the Fed made another announcement today in releasing its first ever Financial Stability Report. The following passage caught my eye.

Working backwards through this excerpt let’s first look at this corporate “sector where leverage is already high.” In fact, it’s higher than at any point over the past couple of decades.

Turning next to “valuations appear elevated relative to historical levels” it’s pretty clear that, according to any number of measures, the equity market is about as overvalued today as it has ever been.

Put extreme equity valuations together with extreme corporate leverage and you get the most overvalued corporate sector in history.

Finally, while valuations demonstrate that “appetite for risks in general” have been extremely high in recent years, there are a number of signs recently that show this is in the process of shifting. Risk appetites in corporate bonds appear to be rapidly waning.

At the same time, risk appetites in equities also appear to be waning at an equally rapid pace.

The combination of extreme valuations and waning risk appetites means, in the words of the Fed, the “resulting drop in asset prices might be particularly large.” Large relative to what? The bear markets of the past couple decades? If so, investors ought to be a bit more worried than they appear at present.

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