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Why the Fed Supports Current Equity Valuations

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FOMC members on equity valuations

The FOMC’s (Federal Open Market Committee) July meeting minutes indicated that FOMC members discussed current equity valuations as part of their discussion on financial stability. The members were of the opinion that macroeconomic factors have been favorable for the equity markets (SPY) and have provided support to current higher valuations. A few members said that the current rise in the markets (QQQ) hasn’t been helped by a greater use of leverage and thus might not be posing any threat to financial stability. One of the members said that the recent rise in equity markets could be part of a larger adjustment to financial assets in which investors were pricing in lower neutral interest rates for a longer period.

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FOMC members see no major risks to financial stability

Financial stability is assessed on the level of capital in the banking (XLF) system, which seems to be in control. FOMC members said that the banking system is adequately capitalized and has enough liquidity, thus reducing the risks to financial stability.

Risks that were discussed by FOMC members

According to the minutes of the FOMC July meeting, members said that it was necessary to monitor financial institutions. They said that shifts in the behavior of financial institutions, especially in lending standards and sources of funding, could lead to problems in the banking sector (IYF). Members felt that declining volatility (VXX) and a heavy concentration of investments by investors in a single asset class could create financial imbalances in the future. Members also expressed concerns about the pace of increase in real estate, especially in the multi-family segment, as a rapid increase in prices could also be a source of financial instability in the future.

To summarize, the FOMC July meeting minutes give us a sense that the FOMC members continue to remain focused on inflation for the time being, and the balance sheet reduction program could be announced at the September meeting.

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