There were two explicit warnings about stock market valuations in the latest Fed Minutes: first, the Fed warned that "vulnerabilities associated with asset valuation pressures had edged up from notable to elevated, as asset prices remained high or climbed further, risk spreads narrowed, and expected and actual volatility remained muted in a range of financial markets." Then, in an odd admission, the Fed said that "recent rises in equity prices might be part of a broad-based adjustment of asset prices to changes in longer-term financial conditions, importantly including a lower neutral real interest rate, and, therefore, the recent equity price increases might not provide much additional impetus to aggregate spending on goods and services." In other words, the entire premise behind the "wealth effect" - the assumption that high stock prices will lead to a boost in spending - may have been, oops, wrong.
One day later, Dallas Fed president Robert Kaplan picked up where the minutes left off with a discussion of market valuations, and said that while risks associated with high stock valuations may be "elevated" he is not worried; what he is worried about “is a correction accompanied with leverage.”
"Market valuation alone isn't enough for me to be alarmed" Kaplan said, explaining that "the thing I’m looking for is the buildup of excesses beyond the valuations - particularly the leverage."
In other words, the Fed is no longer worried just about asset bubbles: it is worried about asset bubbles on margin, and while the market may be at all time highs, just because the Fed is convinced that there is no leverage involved in trading it is not concerned.
This, of course, is patently incorrect, and while it is painfully obvious to any trader just how wrong Kaplan is, the simple explanation for his delusion is that if one looks away from simple margin debt (which incidentally is also near all time highs), the real leverage these days is in Vol-related products: options, futures and ETFs, and it is here that as we showed last week before the VIX explosion, leverage, in the form of VIX-linked Vega has never been higher.
That said, we don't expect the Fed to understand any of this until well after the next crash that will wipe out everyone who has been selling volatility for the past several years, comfortably assuming that the Fed will always have their back.