Unwinding a Bubble is Like Waiting for the Next Shoe to Drop | ETF Trends

Author: Veronica A. Fulton, Research Analyst

In 2008-2009, the banking system and financial markets were on the brink of collapse. To such an extent that the Fed embarked on quantitative easing for the first time ever, after already lowering the Federal Funds rate to virtually zero. These measures were deemed necessary in order to boost borrowing and lending in hopes of spurring economic activity. Principally, the Fed went out into the open market and began buying large quantities of mortgage-backed securities, corporate debt, and longer-term treasury bonds. They paid for the securities by creating “bank reserves” on their balance sheet. The bank reserves essentially backed a new bank deposit owned by the seller of the bonds, which were primarily financial institutions. As a result of those transactions, financial institutions now have more cash in their accounts, which they can hold, use to buy other assets, or lend out to consumers or companies. In August 2007, before the financial crisis hit, the Fed’s balance sheet totaled about $870bn. By January 2015, the balance sheet swelled to $4.5trn. Today the Fed has $8.6trn of assets on its balance sheet. Consequently, many banks now have more excess deposits than ever before.

Banks strapped with liquidity alongside historically low borrowing costs facilitated more risk-taking as cheap capital became easily accessible. Additionally, with the short end of the yield curve being near zero for so long, this left many investors reaching far for yield. This unrestrained yield-seeking encouraged investors to chase some financial asset prices far beyond their fundamental value thus creating bubbles. Companies themselves were able to implement every dream project, profitable or not, by having access to seemingly unlimited zero-cost funding. Simultaneously, they increased equity share prices by borrowing at low costs and buying back stock. For years, financial professionals warned that having to unwind all of the built-up excess liquidity from years of Zero Interest Rate Policy (ZIRP) would be troublesome for financial stability. Over the past year, since the central bank began its tightening path, we have been seeing just that. We’ve seen the rise and fall of some of the riskiest assets, like SPACs, cryptocurrencies, meme stocks, and NFTs. We’ve seen a significant contraction in the valuation of high-growth companies, especially those with negative earnings. The most recent headlines have been Japan’s currency plunging to historical lows, China’s real estate market contracting significantly, the near collapse of UK pension funds, and the most recent bank failures in the U.S. These occurrences can be thought of as bubbles bursting and are a direct symptom of raising interest rates in a debt-laden economy. In recent weeks this has left investors glued to their market screens and news outlets, not knowing exactly what’s coming, but almost certain there’s another shoe to drop.

By nature, bubbles are deceptive, as the euphoria created from constant positive returns causes investors to justify inflated asset prices based on extreme valuations, often tied to unrealistic growth expectations. As such, nobody really knows they’re in a bubble, or more importantly when the bubble is about to burst and how bad the aftermath will be. But it is widely understood that as the Fed continues to suck liquidity out of the markets, it will continuously lead to a valuation reset across a number of assets. For these reasons, we have been and continue to be nimble and on high alert as the market finds its footing and valuations readjust to reflect a higher risk-free rate of return. We’re of the opinion, that as more strain is put onto the financial system, flows will go towards higher quality assets creating bifurcation in the markets. We see this as an environment prime for diversification and active management, as investors will have to become even more selective in where they allocate resources.

Source: federalreserve.gov

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