‘So-Called’ Bubbles

“Asset prices may be vulnerable to significant declines,” the Fed reckoned, in its semi-annual financial stability report.

It was a good candidate for understatement of the year. The S&P, risk asset par excellence, just staged its largest YoY rally in a century. A once-in-a-century surge for a once-in-a-century public health crisis, I suppose.

But the S&P is hardly the locus of concern. It’s true that virtually every traditional asset is trading extraordinarily rich (figure below), but we live in a world where left-for-dead video game retailers can be resurrected with a defibrillator shock administered by traders congregating (don’t say “colluding”) on Reddit.

GameStop’s long-term rating was upgraded by S&P this week, a proof of concept for the retail masses’ capacity to engineer a corporate turnaround. Would any of the corporate actions currently underway at the company be taking place were it not for the meme stock mania? I seriously doubt it.

But even GameStop isn’t the quintessential example of froth. That title goes to Dogecoin, which is now impossible to ignore. It’s up 12,000% this year (figure below), despite being a literal joke.

The Fed was forced to recognize all (or most) of this in its semi-annual report. “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,” the 80-page tome said.

As a general rule, if someone uses “so-called” to preface a discussion about a prevailing trend, it’s usually a good sign the person is behind the curve. It happens to me all the time. The Fed also cited “elevated equity issuance through SPACs” as evidence which “suggests a higher-than-typical appetite for risk among equity investors.”

It was glaringly obvious that policymakers see something more than so-called (oops) “froth” across assets. I’m not sure what the word is for a situation when non-assets, like Dogecoin, sport market caps in excess of $80 billion.

“The Federal Reserve can’t say ‘bubble,’ but if it could, it quite possibly would have done so in its semiannual financial stability report,” Bloomberg’s Brian Chappatta wrote Thursday evening.

While I’m usually quick to note that identifying “bubbles” ahead of time is, in fact, mostly impossible for most people, policymakers included, the effort on the part of the Fed to feign ignorance vis-à-vis its own role in the situation was too belabored this time around even for me. The following excerpt, from the report, borders on the absurd:

In recent decades, risk-free interest rates have declined notably, partly because of a decline in the neutral rate of interest, or the interest rate consistent with the economy being at full employment with 2 percent inflation. Even before the pandemic, a number of estimates found that the neutral rate of interest had declined in recent decades. The decline in the neutral rate of interest likely reflects persistent structural factors such as demographic changes and low productivity growth. While actual interest rates fluctuate with the economic cycle, their trends tend to be driven by the neutral rate of interest. In other words, when, as now, the neutral rate of interest is low, market interest rates also tend to be low.

The connections between persistently low interest rates and risk premiums are not well understood. Persistently low interest rates might contribute to the buildup of financial vulnerabilities through a variety of channels. Because low interest rates tend to be driven by changes in the structure of the economy that reduce expected returns in many asset classes, low interest rates could lead some financial intermediaries to invest in higher-risk assets to meet fixed return targets. By reducing uncertainty about monetary policy, low interest rates could also mute financial market volatility, which could contribute to a buildup in leverage if investors become complacent. Beyond asset valuations, low rates could encourage household borrowing, including through mortgages. Higher household borrowing can support spending and economic activity, but excessive borrowing can increase financial vulnerabilities.

“Could,” “might,” etc. As if there’s any ambiguity here. It’s one thing to claim the benefits of your own policies outweigh the risks, especially during crises. But the steadfast refusal to acknowledge the direct connection between those policies and financial excesses now comes across as deliberately obtuse, not to mention wholly laughable.

George Selgin, a senior fellow at the Cato Institute, said “The real story here is the tension — if not the glaring contradiction — of the Fed’s pursuit of quantitative easing, the aim of which is to lower long-term rates and encourage reach for yield, and their concern that people are indeed reaching for yield.”

Of course, Dogecoin doesn’t “yield” anything, but you have to think about the situation holistically. Traditional investors get pushed out the risk curve and down the quality ladder, from risk-free government bonds all the way into equities, while suppressed cross-asset volatility underwrites various carry trades. That’s all conducive to excessive risk-taking and the almost complete disappearance of price discovery.

Meanwhile, the knock-on effects of that conjuncture begin to show up in vehicles like Cathie Wood’s wildly popular product offerings, the SPAC boom and other highly visible manifestations of what some characterize as speculative excess. That, in turn, pulls in retail investors, whose appetite is further whetted by zero commissions and, most acutely, apps that gamify the trading experience.

This isn’t all the result of the Fed’s policies, but the idea that it can somehow be attributed to the structural economic factors weighing on inflation, growth and thereby risk-free rates in advanced economies is wholly ridiculous.

“It’s honestly an open question if the Fed realizes this or not,” Rabobank’s Michael Every remarked, adding that,

One would like to think they are cynical enough to know what they were doing, and hypocritical enough to then put out reports pretending where we are today is a surprise. Yet there is also the possibility they really are stuck in a crazy mental model and can’t predict that pouring excess liquidity into the financial system, not the real economy, doesn’t drive up productive business investment and inclusive wages, even after years of evidence to that effect. The counter-argument is that the only way the Fed could have injected this much liquidity and not seen it go into houses prices, or stock prices, or agri-commodities, or iron ore, or lumber, or Dogecoin, would have been to accept the market mechanism doesn’t work, and to hypothecate the inflow with the micro and macroprudential measures now flagged too late, or directly via MMT.

I’ll leave you with a few short excerpts (below) from a much longer piece penned by Vassilis Karamanis, an FX and rates strategist who writes a “Trader Talk” column for Bloomberg. I couldn’t resist quoting it for reasons I assume will be obvious.

“What’s the opposite of a bloodbath in financial markets?” a hedge fund trader asked yesterday. “A bubblebath,” he said quickly, and just like that another conversation on cryptocurrencies was underway. Discussing digital coins is always welcome, but it surprised me that someone from the fixed-income world would kick our talk off like that.

I was expecting a comment on gilts given the Bank of England decision was due and the U.K. and French navies were dispatching military patrol vessels toward the isle of Jersey. Or at least a view on Treasurys ahead of today’s US payrolls report. But no, it was about Dogecoin, or jokecoin as some have come to call it. It’s up 11,000% this year so indeed, bubble potential is high. Advocates will probably refer to Mark Cuban’s comments that it will actually become a stablecoin. Or even to Tyler Winklevoss’s tweet from earlier this week: Tyler Winklevoss @tyler Say what you want about $DOGE, but its money supply is harder, more transparent, and more predictable than the US dollar. That’s the real joke.

On a personal note, I had the first dose of my Covid-19 vaccination yesterday. It has been 14 months since the first lockdown so all that came to mind was that scene from my favorite TV series, Breaking Bad: “Yeah Mr. White! Yeah, science!”