The Bloomberg U.S. Financial Conditions Plus Index has reached 2.9 standard deviations above neutral, an unprecedented level that signals the possibility of froth in asset markets in line with the warning by the Federal Reserve’s Financial Stability Report issued on May 6.
The elevated asset prices come amid a debate about the timing and magnitude of the Fed’s eventual move to normalize policy.
This comes at a time when U.S. monetary and fiscal policies stand at extremely accommodative levels, and will play into the debate about the timing and magnitude of the central bank’s eventual move to normalize policy.
Even with these elevated prices, we do not think the Fed will change its policy stance anytime soon.
Slack in the economy remains plentiful and that will need to be addressed as the pandemic recedes and the recovery takes hold. This slack in the real economy and labor markets should bolster the case for continued fiscal and monetary accommodation until the economy returns to full employment.
Some quotient of financial instability is the tradeoff in doing so, and that presents a modest economic risk to the outlook going forward.
The Fed’s warning
In its report on stability, the Federal Reserve went out of its way in its report to talk about high asset prices: “Elevated valuation pressures are signaled by asset prices that are high relative to economic fundamentals or historical norms and are often driven by an increased willingness of investors to take on risk. As such, elevated valuation pressures imply a greater possibility of outsized drops in asset prices.”
While we do not think that this presents a large risk to the economic outlook, it is one that should not be ignored. We would not be surprised to observe stepped-up regulatory activity around an aspect of financial markets causing such financial froth.
Excessively accommodative monetary policies can result in asset-price distortions that have the potential to hurt the financial sector through reduced risk appetite and subsequent diminished economic activity.
For instance, if the return on fixed-income assets is near zero, investors will turn to speculation in the stock market or digital assets, which if a market upset were to follow could have harmful economic implications. That is not what we are forecasting; however, with financial conditions at these levels, it does merit a mention of the risks around froth in financial markets.
The Bloomberg index
The Bloomberg U. S. Financial Conditions Plus Index was formulated to augment the ordinary financial conditions index (shown by the green line in the figure below) by detecting potential financial instability.
We note that bubbles are easy to talk about in retrospect and almost impossible to identify in real time, whether they are in the tech sector, the housing sector or fixed-income markets.
The Plus index has reached above 1.96 standard deviations — which indicates statistically significant stress in the financial markets — on several occasions, including in the run-up to the housing crisis and the 2008 Financial Crisis, and then in 2014.
And there were multiple other incidents between 2017 and 2020, when the combination of extremely low interest rates and elevated prices of technology stocks threatened financial stability. These asset price excesses were clearly on the radar when the Fed tried to normalize interest rates from 2016 through 2018.
Monitoring vulnerabilities in the financial system
Promoting financial stability is a key element in fulfilling the mandate of the Federal Reserve and other central banks of the world. In its latest assessment of the financial system, the Fed finds good news and some vulnerabilities that have cropped up since its last report in November.
First, the good news. The Fed reports that “banks remain well capitalized, and leverage at broker dealers is low.” Furthermore, “funding risks at domestic banks remain low” because of the high quality of liquid assets,” though structural vulnerabilities “persist at some types of money market funds (MMFs) as well as bond and bank loan mutual funds.”
Perhaps best reflecting the government’s quick response to the pandemic is that vulnerabilities “from both business and household debt have declined, reflecting a slower pace of business borrowing and an improvement in earnings as well as government programs that have supported business and household incomes.”
The Fed added that “even so, many businesses and households remain under considerable strain,” particularly among those most financially at risk.
The Fed notes that “prices of risky assets have generally increased since November.” The Fed states that high asset prices are in part a result of continued low level of Treasury yields and that those assets “may be vulnerable to significant declines should risk appetite fall.”
That coincides with our assessment that a speedy resolution of both the health crisis and the economic crisis will allow for the normalization of interest rates and sufficient rates of return on investment necessary for a robust and widespread recovery.
Finally, the Fed is aware of the changing investment environment and will continue to adapt its monitoring procedures to that environment.
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