The Bloomberg U.S. Financial Conditions Index Plus has risen in recent weeks, surpassing an unprecedented three standard deviations above normal levels and signaling an extraordinary level of risk-taking in the financial markets. This risk augurs an increase in regulatory activity, especially when it comes to digital assets.
The Plus index was created to augment the ordinary financial conditions index (shown by the green line in the figure below) by detecting bubbles in the tech sector, the housing sector and fixed-income markets.
It is becoming increasingly likely that the froth in the markets for digital assets and the risk it brings are why federal authorities have begun signaling stepped-up scrutiny.
The Federal Reserve’s recent rhetoric almost surely is a sign that it intends to introduce an American-based central bank digital currency, along with the FedNow service that seeks to deliver a new instant payment infrastructure.
Both will affect financial market valuations and the inchoate market structure that underscores cyber assets.
The recent rise in digital assets is much different from other asset classes. For example, during the pandemic, the value of homebuilder exchange-traded funds increased by 144% between March 2020 and May 2021. This was because of heavy demand for new housing and shifts in residential spending during the pandemic.
Investment in housing stock, however, will generate consumer spending and has been the major factor in the accumulation of household wealth for generations. The same cannot be said about speculative digital assets.
But admittedly, there were bound to be bubbles in other areas of investment that would bleed into the financial markets. We attribute recent speculative demand for alternative assets to the lack of return in the fixed-income market. We have seen this search for yield before, but in this peculiar era of pandemic investing, we are seeing it in spades, and it carries sufficient risk that warrants a response by regulatory authorities.
From March 2020 to May 2021, there was a 175% increase in the share price of GameStop, a videogame retailer. And the value of Bitcoin, a cryptocurrency, increased by 490%.
Neither of those assets is a store of value and Bitcoin could not be construed as a stable alternative to the dollar or the other major currencies.
But investor exposure to the 44% drop in Bitcoin trading in the just the past six weeks or to the 90% drop in GameStop share prices in February—followed by a 30% drop a few weeks later—nevertheless presents a threat to financial stability.
Asset-price bubbles have the potential to burst, which can cause a freeze-up in the financial sector and the potential for an economic disaster. While we do not expect the Fed to reverse policy at this point, we anticipate the monetary authorities to seek regulatory remedies.
The economy needs to be revived quickly so that fixed-income securities can once more offer a sufficient and stable rate of return for household and business investment.
For more information on how the coronavirus pandemic is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
