(Bloomberg) -- The U.S. agency that analyzes threats to financial-market stability is waving a red flag about elevated stocks and bonds.
Overall, the risks to financial stability remain in the “medium range” and the system is far more resilient than a decade ago during the financial crisis, according to Treasury’s Office of Financial Research, an oversight body that was created by the post-crisis Dodd-Frank reforms. But vulnerabilities have emerged in the past year amid too much borrowing.
“Although our overall assessment is moderate, market risks are high and rising from the potential for a sudden drop in the prices of assets in financial markets, particularly the stock markets and bond markets,” the agency said in its annual report to Congress on Tuesday. “Such a decline could exploit vulnerabilities from excessive leverage, when resources are too low in relation to investment exposures.”
U.S. stock markets have been on a record-setting streak, with the S&P 500 touching another new all-time level Tuesday. Treasury yields, which move in opposite direction of debt prices, have risen in recent weeks yet remain below long-run averages. The 10-year yield, at 2.36 percent, is less than half the 6.2 percent average back through 1962.
The OFR report pointed to stock market valuations at record highs, elevated prices in the bond market and low risk premiums for corporate bonds, and said high leverage can be a destabilizing factor in the event of a correction. These warnings follow similar ones recently from the Basel, Switzerland-based Bank of International Settlements and Goldman Sachs Group Inc. A prolonged bull market across stocks, bonds and credit left a measure of average valuation at the highest since 1900, according to Goldman’s analysis.
The agency said that it’s been warning in all of its reports since 2012 that low volatility in market prices amid persistently low interest rates could encourage “excessive risk-taking" by investors and future vulnerabilities.
Treasury Secretary Steven Mnuchin has said that the enactment of tax cuts will further fire up the stock market. The Senate passed a sweeping bill last week that moves the Trump administration a step closer to signing a tax-overhaul into law by its year-end goal.
Separately, the Federal Reserve Bank of New York this week said its yield-curve-based gauge of recession chances a year from now rose to almost 11 percent, the highest level since 2009, when the economy was still in the throes of its last contraction.
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