Our composite RSM US Financial Conditions Index is falling, reaching nearly one standard deviation below zero as the situation in Ukraine continues to threaten trade and global financial stability.
The negative trends in the equity, money and bond markets imply a reassessment of the economic recovery, which would require additional compensation for the risk of holding securities. The move into negative terrain implies that financial conditions are now a drag on growth.
The equity market was the first of the markets to signal that degree of risk. After nearly a year of solid performance, the yearly return of the S&P 500 is below the average levels of the past 52 weeks. At the same time, volatility has increased to levels associated with the global financial crisis, the European debt crisis, the U.S. trade war and the pandemic.
The spreads between commercial money market interest rates and risk-free instruments continue to widen, signaling increased potential for distress. If spreads were to continue to widen, however, we expect central banks to step in and flood the markets with liquidity as they have done in the recent past.
The Treasury yield curve continues to flatten. Yields on 5- and 10-year bonds have fallen by more than 20 basis points since the end of February, most likely in response to increasing perception of risks to economic activity caused by the war and by the increase in safe-haven demand for U.S. securities.
At the same time, the upward trend in two-year bonds looks to be stalling. Because short-term Treasury yields anticipate the path of monetary policy, the bond market now appears to be reassessing the Federal Reserve’s response to inflation in light of disruptions to growth.
Yields in the corporate bond market spiked higher and spreads with 10-year Treasury bonds widened as additional uncertainty is priced into holding investment-grade and high-yield bonds.
