In the semi-annual “Financial Stability Report” (FSR) released this Thursday, the Federal Reserve issued a warning about the “Special Purpose Acquisition Company” (SPAC), a new backdoor listing financing model “Special Purpose Acquisition Company” (SPAC) that appeared this year when retail investors flocked to small-cap stocks, saying that the rise of such popular stocks and SPACs reflects the extremely high risk appetite of stock market investors, and once such preferences cool down, it may overwhelm US stock asset prices.

The FSR report argues that in various asset markets, risk appetite is driving up valuations, making the US financial system vulnerable.

“When risk appetite is high, investors may use too much leverage or take other forms of risk action. These are the vulnerabilities mentioned in the Federal Reserve's financial stability framework. Moreover, once risk appetite falls from a high level, a wide range of asset prices may be overwhelmed by sharp declines and sudden declines, which will put pressure on the financial system on a wider scale.”

The report mentions individual stocks such as GME (GME) that retail investors rallied with bears earlier this year — the so-called meme stock, saying:

“Some indicators show that the risk appetite in the stock market was high at the beginning of this year, including the high trading volume and price fluctuations of meme stocks. The volume of these individual stocks increased after they went viral on social media. The high level of IPOs issued through SPACs also shows that the risk appetite among stock investors is higher than normal.”

In a statement issued at the same time, Federal Reserve Director Lael Brainard, who leads the Federal Reserve's Financial Stability Committee and was rumored last year that he may succeed Powell as the next Federal Reserve Chairman, placed special emphasis on a few weak points:

• Vulnerabilities associated with high risk appetite are increasing. Valuations of a range of asset types were high at the end of last year and have continued to grow. Stock market indicators have reached record highs, and the price-earnings ratio is expected to be close to historic highs. “Risk appetite has generally increased, as the meme stock shows”.

• “The corporate bond market also has a high risk appetite. Interest spreads on low-quality speculal-grade bonds compared to US Treasury yields are already at the narrowest level we have ever seen.”

• Overvalued, combined with high levels of corporate debt, this situation is worth paying attention to, as it may amplify the impact of the repricing incident.

The FSR report also mentioned that the family office Archegos, which used high leverage, burst out of business at the end of March this year, saying that the Archegos incident caused losses to many large banks, and emphasized that non-bank financial institutions such as hedge funds and other investors using high leverage caused huge losses to the financial system.

According to the report, the indicators currently available show that the leverage of hedge funds is higher than the historical average to a certain extent, and the Archegos incident proved that “the visibility of hedge fund risk exposure is limited”. It reminds everyone that “existing hedge fund leverage measures may not be sufficient to capture important risks.”

Referring to the Archegos incident, Brainard said that the possibility that hedge funds will operate extremely poorly will affect the wider financial environment. This possibility highlights the importance of improving the accuracy and frequency of hedge fund information disclosure.

Brainard concluded that at a time when investors are confident about the prospects of a strong economic rebound, it is important to closely monitor the risks of the financial system and ensure the system's resilience. Since asset valuations and risk appetite are high, strong macroprudential tools such as countercyclical capital buffers (Countercyclical Capital Buffers) and some microprudential guarantees will be important if financial stability risks are to be mitigated and monetary policy is to focus on achieving full employment and average inflation targets.