When Federal Reserve Chair Kevin Warsh said that the central bank withdrew a degree of accommodation from the economy he was spot on as far as our RSM US Financial Conditions Index is concerned.
In the aftermath of the Fed’s rate hike last month, global bond markets sold off and equity markets declined.
During the most recent week, financial markets removed another degree of investment accommodation. After a year of near complacency, our RSM US Financial Conditions Index declined to less than 0.3 standard deviations from normal levels of risk.
While financial markets remain somewhat less accommodative than earlier this year, they are not tightening.
Financial markets continue to do the work of the Fed as inflation surges and the central bank contemplates skipping what we think should be an October rate hike and instead will wait until December.
But that is only part of the story.
The money market component of our financial conditions index turned negative for the first time since 2023, and the bond market is barely positive. That leaves only the equity market as holding overall financial conditions at a slightly accommodating level.
Equity market
We should start with an equity market that was already questioning whether the tech sector had reached overbought levels.
It only took the declaration to increase borrowing by the AI cloud provider CoreWeave, whose debt had fallen under pressure, to push tech-centered equity indices lower and to push market volatility higher.
Still, and despite last week’s 1.9% drop in the S&P 500, returns in the tech sector this year remain high enough to keep the equity market component and overall financial conditions above water.
But it didn’t stop there.
Bond market
The CoreWeave incident was enough to remind investors that the equity market has an inherent all-or-nothing element of risk. That in turn made the 5% guaranteed returns in the bond market look all the more attractive.
In the 12 months before CoreWeave, long-term interest rates had increased across all maturities. This rise signaled the increased risk and cost of trying to sell a fixed-rate security at a moment of extreme geopolitical uncertainty and inflation and with policymakers who remain unwilling to address runaway public debt.
That appeared to change overnight, with 2-year Treasury yields dropping by 25 basis points from 4.95% to 4.70%, the 10-year yield dropping by 25 basis points from 5.3% to 5.1%, and the 30-year dropping by 20 basis points from 5.6% to 5.4% after trading above 5.7% in the prior week.
Volatility in the Treasury market has been spiking toward crisis levels of the past two years, reaching high enough to reduce accommodation to neutral levels.
Money market
Because of the rising cost of servicing government debt, the U.S. Treasury has resorted to issuing its new debt and rolling over existing debt into lower-yielding Treasury bills.
That worked smoothly until September’s rate-hike program and what is now the Fed’s hawkish view of inflation.
That shift leaves money market funds avoiding Treasury auctions and instead parking funds in overnight facilities where returns are guaranteed. There are also reports of a drop in money-market assets this year, implying further drops in the demand for T-bills.
The effect of the over-supply can be seen in the money-market yield curve from 3 months out to 12 months, with investors preferring the safety of overnight returns and with the OIS rate trading above 4% in four of the past five weeks.
Finally, the current 2-year bond yield at 4.7% is anticipating multiple 25 basis-point Fed rate hikes.
The takeaway
While overall financial conditions remain somewhat accommodative, the money and bond markets are highlighting the policy distortions that could weigh on investment should the recent repricing of risk accelerate.
The Fed’s next move is likely to be at its December meeting.
The 2-year Treasury yield at 4.7% is anticipating up to three more Fed rate hikes.
