The Fed Ignores a Key Bubble Risk for the Stock Market

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.


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.”