The Federal Reserve lowered its policy rate by a quarter-point last week, noting that a shift in the balance of risks to its dual mandate of maximum employment and stable prices warranted what Chair Jerome Powell called a “risk‑management cut.” In addition, the “dot plot” in the Summary of Economic Projections pointed to two additional cuts by the end of the year and one more next year, for a total of 1% by the end of 2026, according to the median projection.

With conditions in the U.S. labor market cooling, the Federal Open Market Committee judged it appropriate to take a step in returning to a more neutral policy stance, even though inflation is still well above the 2% target.

But is U.S. monetary policy really tight? Most of the debate has been on the gap between measures of short‑term real interest rates and estimates of a long‑run neutral real rate — determined by structural forces including demographics, productivity and the global balance between savings and investment.

An alternative way to answer this question is to consider financial conditions — a summary of the overall tightness or looseness of conditions in financial markets. Ultimately, what matters are the borrowing costs of households and firms and the availability of credit. Whether monetary policy is too loose or too tight should be assessed relative to prevailing financial conditions in the broader economy.

By that standard, financial markets are ebullient. Stock prices are at or close to record highs, credit spreads are extremely compressed, volatility is low, IPO activity is accelerating and speculative markets in areas such as cryptocurrencies and meme stocks are surging.

With the Fed signaling a shift to risk‑management mode and investors pricing in four cuts or even more through the end of 2026, there is a risk of a “melt‑up” in financial markets in the coming months. With lax financial conditions and asset prices showing signs of froth, investors may be incentivized to take on more debt to boost expected returns from investment.

The economic recovery since the pandemic has been fueled in large part by government borrowing and less so by private‑sector balance sheets, which look seemingly healthy in aggregate. Household debt (as a share of GDP) has continued to fall — a decline that started after the 2008 financial crisis — and growth in nonfinancial corporate debt has been muted.

A concern is that, with short‑term interest rates expected to decline, investors will start to aggressively deploy financial leverage in the form of repurchase agreements, prime brokerage borrowing and financial derivatives, just to name a few, juicing returns at a time when risk assets are expensive.

Financial leverage is more insidious than traditional on‑balance‑sheet debt at banks. It is more difficult to assess, given that there is no simple way to aggregate different financial instruments that investors can use. It is also more difficult to track by both policymakers and market participants, given a lack of widely available, granular and timely data. Importantly, there is always a “touch point” on banks’ balance sheets (Financial Stability Report — April 2025), which makes it systemic by definition.

A notable increase in the use of financial leverage would be particularly pernicious at this late stage of a long financial cycle. Retail participation in financial markets has been growing amid the gamification of trading, coinciding with a boom in speculative cryptocurrency trading. Market enthusiasm has been fueled by expectations of financial deregulation by the Trump administration, further contributing to robust risk appetite, even though tighter supervision and regulation may be warranted.

Shock to stocks and bonds

A buildup in financial leverage would make the financial system more vulnerable and susceptible to shocks, especially during heightened economic and policy uncertainty.

The list of possible shocks is long: a spike in inflation as tariffs seep in; a sudden deterioration of the U.S. fiscal outlook (for example, if the Trump administration’s authority on tariffs is curtailed by the Supreme Court); growing concerns about the loss of Fed independence; a disappointment of investor expectations about AI‑driven productivity gains; or a deterioration of geopolitical tensions.

While each shock would play out differently in various corners of the financial system, the danger is the unraveling of a sudden, pernicious feedback loop between sharp declines in risk asset prices and forced deleveraging, which would lead to fire sales and put further downward pressure on asset prices. In a world where inflation is still above target, the tension between price stability and macro‑financial stability would put the Fed in a difficult spot.

For investors who have been sitting on the sidelines, it may be tempting to cave in to FOMO — the fear of missing out — and jump in when a rising tide lifts all boats. But it is very hard to time the market. The belief that old rules of valuation, risk and financial cycles no longer apply — “this time it’s different” — has been proven wrong innumerable times in the history of finance, including during episodes of rapid technological advances when enthusiasm blinded investors to the risks. This party may continue for a while, but ultimately, fundamentals will reassert themselves, and the last guests joining the crowd won’t have much to celebrate.

Fabio Natalucci is the CEO of the Andersen Institute for Finance & Economics.