BackThe US Fed came as close as it could to calling out a ‘bubble’
Inflated equity prices at least got a mention in its stability report
PremiumThe US Federal Reserve can’t say “bubble". But if it could, it possibly would have done so in its latest semi-annual financial stability report, which used the phrase “meme stocks" not once, not twice, but thrice. The central bank said that it views valuations for some assets as “elevated relative to historical norms even when using measures that account for Treasury yields. In this setting, asset prices may be vulnerable to significant declines should risk appetite fall." In particular, it highlighted some of the most bubbly areas of the financial markets: Initial public offerings, special purpose acquisition companies, and, yes, those meme stocks.
In contrast to the mixed signals from price-based measures, a number of other measures suggest that investor appetite for equity risk is elevated relative to history. The pace of initial public offerings (IPOs) has increased to levels not seen since the 1990s. Plus, a rising share of IPOs is supported by special purpose acquisition companies (SPACs), which are non-operating corporations created specifically to issue public equity and then acquire an existing operating company.
High asset valuations, relative to the general level of interest rates and the income flows generated by different types of assets, suggest investors require less compensation for the risks they are taking, and thus have elevated appetite for or willingness to invest in risky assets.
Indicators pointing to elevated risk appetite in equity markets in early 2021 include the episodes of high trading volumes and price volatility for so-called meme stocks—stocks that increased in trading volume after going viral on social media. Elevated equity issuance through SPACs also suggests a higher-than-typical appetite for risk among equity investor.
This is about as close as the Fed can get to saying that certain asset prices are out of control. As it so happens, it was released at the close of a trading session in which some of these high-fliers started to come back to Earth. The Renaissance IPO exchange-traded fund (ticker: IPO) tumbled 4.2% in its longest losing streak since September 2015 to its lowest in about six months. The Defiance NextGen SPAC Derived ETF (ticker: SPAK) fell almost 3% on Thursday and is now down more than 30% from its February peak. The ARK Innovation ETF (ticker: ARKK), whose fund manager Cathie Wood inspired a range of T-shirt designs, closed at the lowest since November after the longest streak of outflows since it launched in 2014.
Of course, this hardly means the financial markets are wringing out the speculative excess. Instead, it’s just migrating elsewhere to arguably even riskier bets— namely to cryptocurrencies such as Dogecoin and Ethereum Classic. As my Bloomberg Opinion colleague Matt Levine succinctly put it, “Dogecoin’s status as a joke is what makes it valuable… being the funny Bitcoin—the hilariously worst Bitcoin, even—gets attention, and attention is the most valuable thing in the world."
I would wager that the Fed isn’t laughing about it. Still, a quick search of ‘crypto’ in the financial stability report turns up only one result: a table on page 68 of 80 that shows cryptocurrencies rank as the ninth-most-cited potential shock over the next 12 to 18 months, trailing comparatively mundane topics such as the drawdown of the Treasury general account and threats that are always out there, like cyberattacks. For better or worse, the central bank isn’t yet ready or willing to wade into the debate about the exponential increase in the value of crypto assets. Remember, its previous report was released in November, when Bitcoin was trading at about one-fourth of its current value. It’s telling that the rapid price appreciation did not even warrant a mention this time.
The Fed also briefly mentioned the blowup of Archegos Capital Management, and Governor Lael Brainard specifically called out the event in a separate statement. “It illustrates the limited visibility into hedge fund exposures and serves as a reminder that available measures of hedge fund leverage may not be capturing important risks. The potential for material distress at hedge funds to affect broader financial conditions underscores the importance of more granular, higher-frequency disclosures," said Brainard, who is a potential candidate to succeed Fed Chair Jerome Powell next year and has made an effort to differentiate herself by taking a tougher stand on financial regulation.
But it’s the US Fed’s view on asset valuations that will rightfully be the focus of this report. Powell himself caught traders’ attention after last month’s Federal Open Market Committee meeting by declaring that parts of the markets “are a bit frothy, and that’s a fact." Now we know which areas he was talking about.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets.
©bloomberg
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