People walk past the Federal Reserve building on March 19, 2021, in Washington. Photo: AFP / Daniel Slim

The handful of tech giants represented in the “FANG” index (Facebook, Amazon, Netflix, Google and friends) rose in price by nearly 13 times since January 2013, while the S&P 500 rose only 2.8 times.

They earn only 0.7% of the S&P 500’s total revenue, but account for 12.2% of its market capitalization. This remarkable divergence of valuation might be the biggest bubble in market history: As the “real” or inflation-indexed yield of US Treasury securities fell into deeply negative territory, the price of tech stocks rose in a nearly perfect straight line.

Without tech stocks, it doesn’t feel like a rally. While the S&P 500 closed last week at a new high, 334 of its members traded at a one-year low, while fewer than half as many hit new highs. Market breadth, as the analysts call it, is miserable.

Investors are buying tech stocks the way they used to buy utilities, as a source of monopoly income streams whose value depends on the return to the risk-free alternative, in this case real Treasury yields.

But the collapse of real yields in turn is an artifact of Federal Reserve stimulus. The Fed owns most of the outstanding inflation-indexed securities. What happens when the Fed “tapers” its buying, as it has promised to do? The letdown could be abrupt and brutal.

The NY Fang Index (Tesla, Google, Apple, Microsoft, Meta, Netflix, Amazon, Baidu and Alibaba) traded in a straight line with the inflation-indexed Treasury yield. 

The negative 1.5% yield of 5-year TIPS, the driver of stratospheric tech-stock valuations, requires some explanation. The 5-year TIPS yield for the past dozen years tracked the Federal Reserve’s overnight lending  (federal funds) rate, or more precisely, the market’s best guess about where the overnight rate will be in a couple of years.

We know what the market thinks about the future overnight rate from the futures market.

As the chart shows, this relationship diverged noticeably after the pandemic began in 2020. The expected federal funds rate rose about 1.25% from the zero level set by the Fed in response to the Covid recession, but the 5-year TIPS yield kept falling.

There’s no mystery as to why TIPS yields fell. The Fed bought nearly $300 billion worth of TIPS starting in the second quarter of 2020. If it stops buying TIPS, the TIPS yield should rise in keeping with its long-term relationship to the expected federal funds rate.

If the historical link prevailed, the 5-year TIPS yield would snap back by 1.5 percentage points, from about -.5% now to positive 1.5%. And if the historical link between the 5-year TIPS yield and FANG stocks held up, the FANG index would fall from about 7,500 to 5,000 or so.

There are only $550 billion of TIPS issued, and the Federal Reserve owns nearly $400 billion of them. The TIPS yield is whatever the Fed wants it to be. And the lower the TIPS yield, the higher the price of tech mega-cap stocks.

I am not implying that the Fed is in cahoots with Big Tech to boost stock prices, but if it were, it couldn’t have managed things better.

Now the Fed has promised to “taper” its purchases of Treasuries. Whatever the Fed does, it will do gradually. It knows painfully well that the stock market’s elevated valuation rests on the air-pocket of unprecedented Treasury yields.

But the Fed also has its credibility to look to. After insisting for months that inflation wasn’t there, and that if it was there, it was transitory, the Fed fears that it may have set off an inflation cycle like the miserable 1970s.

It has indicated that it will raise its overnight rate from zero to about 0.75% over the next year, and “taper” (but not entirely stop) its purchases of Treasury securities. 

I don’t know what the Fed will do, and neither does the Fed. But it has painted itself into a corner with the biggest monetary stimulus in peacetime history, and cannot back out of it without making a mess.