When the Federal Reserve released its semiannual financial stability report in May, I wrote that the central bank came as close as it could to saying “bubble.” So imagine what it could have said in its latest update, which was released on Monday.
After all, in the six months since the first report, the S&P 500 has advanced 13%, Bitcoin has reached unprecedented heights, with the broader crypto market surpassing $3 trillion in size, and even special purpose acquisition companies have clawed out gains. If markets weren’t in a bubble in May, it sure feels as if they’re in one now. And yet the Fed is showing no urgency to do anything to manage this risk.
In particular, the central bank’s decision to slow-walk its policy tightening is having ramifications for inflation-adjusted rates on U.S. debt as bond traders rapidly expect faster price growth for longer. The yield on 30-year Treasury inflation-protected securities plunged to a record low -0.578% on Tuesday, reflecting the difference between the nominal long bond, at 1.82%, and the market’s estimate of annual price growth over the next three decades, at 2.4%. Before the Covid-19 pandemic, the 30-year real yield had never fallen below zero.
Real yields are one of the most common rationales for why stocks continue to set records and defy gravity. They’re a core part of the “There Is No Alternative” (TINA) thesis: Why own bonds that won’t even net a positive return after inflation? Might as well throw money at pricey equities, where companies at least have the chance to pass along cost increases to consumers and bolster profit margins.
Citigroup Inc.’s Matt King summarized the current dynamic in a recent Odd Lots podcast with Tracy Alloway and Joe Weisenthal:
“Investors have been trained almost: Oh, don’t look at the underlying fundamentals, they haven’t got anything to do with the market price. It’s only about the stimulus, it’s only about the real yield. And they’re seeing real yields back at the lows and they’re saying, well, therefore there’s nothing to worry about.
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The long-term story, the slightly scary story is, the last few cycles have not really gone according to plan. At no point, at least until now, have the central banks had to raise rates to shake off an inflationary and overheating economy. And what’s triggered recessions has instead been accidental bursting of asset price bubbles. And the scary bit is that each time it’s been a lower level of real yields, which has triggered that bursting of an asset price bubble. And it’s almost as though it’s taking a lower and lower level of real yields or a larger and larger degree of stimulus to keep investors holding on to fundamentally expensive assets.”
None of this is what the Fed wants to hear, obviously. Policy makers are sensitive to the tenuous recovery from the pandemic shock and seem intent on keeping consumer demand elevated, even if it means letting inflation run hot. It helps explain why, even with financial conditions just about the easiest they’ve ever been, the central bank is only ever-so-slightly tiptoeing back from its emergency $120 billion of monthly asset purchases, likely pushing any interest-rate increases off eight months at least.
One common refrain from investors goes something like this: The longer the Fed allows negative real yields to push equities to new records, the more painful it might be when it finally decides to raise interest rates. It sounds like typical Fed grumbling and caution — until you realize just how much Americans are counting on persistent stock market gains.
According to the Fed’s own survey of consumer finances from 2019, 47.8% of Americans younger than 35 had either direct or indirect stock holdings, the largest share since 2001. That makes sense. As the central bank noted in Monday’s report, “because equities feature higher volatility and expected returns than many other financial assets, they tend to be more attractive to younger and less risk-averse investors.” It added that “access to retail equity trading opportunities has expanded over the past decade. One factor contributing to this expansion has been the elimination of trading commissions at major retail brokerages.”
But because the Fed has been locked near the zero lower bound of interest rates for so long, it seems to have changed the calculus for older investors, too. Some 51.5% of those who are 65 to 74 held stocks in some form as of 2019, up from just 30% in 1992. And for those 75 and older, stock holdings have never before commanded a greater share of their overall financial assets, at 54.9%. YOLO, indeed.
This shift has potentially destabilizing consequences because it stands to reason that older investors would be more skittish about preserving gains during in any market swoon. Earlier this year, finance professors Xavier Gabaix and Ralph Koijen won the 2021 AQR Insight Award for a paper titled “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis.” In it, they argued that a $1 inflow into equities has a “multiplier effect” that will increase the market value of all stocks by about $5, with the reverse also holding true, even if it’s based on no information whatsoever. “The aggregate stock market is surprisingly price-inelastic, so that flows in and out of the market have a significant impact on prices and risk premia,” Gabaix and Koijen conclude.
That kind of rush for the exit is precisely what worries central bankers. “Asset prices remain vulnerable to significant declines should investor risk sentiment deteriorate,” the Fed said in its financial stability report. Slow progress on containing the virus or a stalled economic recovery were also cited as concerns. Deeply negative real yields, on the other hand, barely merited a mention, even though few question their significance in propping up a debt-laden financial system.
Meanwhile, the most-cited potential shock in the next 12 to 18 months was persistent inflation and monetary tightening. On Monday, a separate release from the New York Fed showed consumers’ median one-year inflation expectations continued to surge, to a series high of 5.7%. While some central bankers are sticking to their previous views that rate increases won’t be necessary until 2023, others seem more inclined to tighten starting next year.
The Fed’s commitment to keeping policy accommodative until the economy reaches maximum employment is a noble intention. But in glossing over how the dynamic between the labor market and inflation has changed, it’s allowing financial stability risks to fester. Citigroup’s King put it best: “Everything has become correlated with real yields, everything has become correlated with central bank policy.” If only the Fed had recognized that in its own report.
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