The Federal Reserve doesn’t see risks to market stability, even as concern about bubbles grows

Some market pros see the frenzied short squeezes in Gamestop and other stocks as signs of a bubble brewing, but the Federal Reserve doesn’t seem to and for that reason investors expect asset prices could continue to rise.

Fed Chairman Jerome Powell, at his post meeting briefing Wednesday, was asked about the potential of Fed policy to fuel bubbles in markets and in housing.

Powell explained that the Fed has had to use its extraordinary policy to help the economy with still more than 9 million people out of work.

“It’s very much appropriate that monetary policy be accommodative,” he said. Powell also said with regard to financial stability, the Fed considers asset prices, leverage in the banking system and non banking system, as well as funding risk.

“I would say financial stability vulnerabilities are overall moderate,” he said, adding the Fed’s goals are also to prevent long-term damage to the economy and make sure the financial system is resilient to shocks. He said he believes the run up in housing prices is temporary, and the pandemic has created a surge in demand because of people working from home.

“I think he’s reluctant to talk about specific stocks and even when he was asked about the housing market, he feels as though some of that is specific to the idea that supply was constrained, and there was pent-up demand and it’s temporary,” said Michael Arone, chief investment strategist at State Street Global Advisors. “I wouldn’t expect the Fed chairman to acknowledge that Fed policy helps create bubbles.”

The Fed’s zero rate policy has helped fuel a mortgage boom with record low lending rates. Home prices were up 9.5% in November from a year earlier, the strongest annual growth rate in over six years, according to S&P CoreLogic Case-Shiller Home Price Indices. It is one of the strongest annual gains in the 30 year history of the data.

Stocks were lower Wednesday, with the S&P down 2.6%, its worst loss in three months. But Gamestop continued its parabolic run higher Wednesday, gaining 135% on the day. AMC was up 300%. Retail investors have also been buying out of the money call options at a record pace.

“A growing majority of investors don’t know anything about balance sheets, financials and could care less about management’s vision for their companies,” said Chris Rupkey, chief financial economist at MUFG Union Bank. “They like it because it’s cheap. It’s low in price and they’re going to buy it preferably with options.”

Rupkey said that behavior smacks of a bubble and investors that just think stocks will go higher. “If the bubble is partly caused by Federal Reserve policy, they’re not going to stop dishing out money for some time,” said Rupkey.

When the pandemic hit markets hard last March, the Fed responded quickly to the unprecedented shock by taking interest rates to zero and unrolling programs that provided an assortment of vehicles to help keep financial markets liquid.

The Fed reversed a freeze up in credit markets and a stock market crash. Many of the programs are still in place with the exception of several that were allowed to expire in December by the Treasury.

Arone said he has been concerned about the Fed making a policy mistake this year.

“The less likely mistake is they tighten prematurely. I think the more likely mistake is they let a bubble form,” he said. “It’s exhilarating on the way up, but it ends when rates start to pick up.”

Arone and other stock strategists have expected a stock market pullback in the beginning of the year, after the big runup in stocks since November. Any dip would create a buying opportunity since they expect the economy to improve as the vaccine is rolled out and fiscal stimulus kicks in – and Fed policy remains supportive.

As for the short squeeze traders, Arone said it’s a warning of bubble behavior. “What’s going on there is a group of folks on Reddit are targeting stocks with a high amount of short interest. It’s very specific, what’s going on with AMC and what’s going on with Gamestop,” he said. “But I do think you have this growing investor class of very brazen folks. You have this intersection of technology, zero commissions and fractional shares that creates this investor class that’s very aggressive, and with these platforms they can be a big group. And that’s a red flag.”

He said the Fed’s easy rate policy helps support stocks. “I think it’s funny when here we are in 2021 and really all this began in the aftermath of the global financial crisis, maybe even earlier, the Fed manipulation interest rates below growth rates, below the rate of inflation. It supports asset prices,” he said.

Arone said the Fed and markets also seem at odds over whether more stimulus is needed. He said some investors clearly want to the Fed to do more, but the Fed is holding back on further policy moves, like changing the duration of bonds it is buying or increasing its purchases.

“I think behind the scenes, the Fed is watching markets. They will not acknowledge some of the frothiness in some of these places,” he said. “But you can rest assured they see what’s going on and probably they don’t want to create yet another asset price bubble.”

Powell, during the briefing, said the latest runup in asset prices was not due to monetary policy but due to news on vaccines and fiscal stimulus.

“He’s overstating the ability of the Fed to help the economy and understating its ability to help markets,” said Peter Boockvar, chief investment strategist at Bleakley Global Advisors. “He keeps deflecting.”

Boockvar said the Fed’s policy impact is clearly felt across markets, including junk bonds where yields are at historic lows and some prices are at record highs.

“They’re solely focused on the virus and they don’t care what the side effects are of what they’re currently doing. Buying $80 billion of short term Treasurys, how does that translate to better economic growth?” he said. “Powell was so nonchalant about these hikes in home prices. It’s just temporary. Tell that to the first time homebuyer who is trying to buy a home and keeps getting outbid.”

Rupkey said the Fed is more concerned about other problems, and does not see an issue yet.

“This Federal Reserve is not going to respond to asset prices unless they go up another 100%. This Fed is more concerned than ever about maximum employment,” Rupkey said “helping those on the very fringe of the labor market.”

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