As the Federal Reserve’s policy framework evolves, financial conditions are assuming a greater place in its decision-making.
One week after the Fed raised the overnight rate by 25 basis points, financial markets appear to be preparing for the tightening of financial conditions.
This is important in light of Fed Chairman Kevin Warsh’s recent statement that he’s not one to react to every economic data point, preferring instead to monitor financial conditions.
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Financial conditions are at the core of modern-era U.S. monetary policy, serving as the transmission conduit from monetary and fiscal policy to the economy.
They are a gauge of the willingness to borrow or to lend, which is essential for risk taking and investment, and the financing of economic growth.
At present, financial conditions remain somewhat accommodative, signaling the potential for growth. And one part of Warsh’s rationale for hiking rates was to remove a degree of accommodation from an economy that is likely to grow between 2.5% and 3% in the current quarter.
But that accommodation appears to be slowly slipping, with signs of increased risk in the bond market overshadowed by smooth operation in the money market and an equity market that continues to offer elevated returns.
Our RSM US Financial Conditions Index continues to indicate still accommodative financial conditions, dropping slowly to 0.8 standard deviations above neutral.
Equity market
The equity market remains above water based on the still-elevated returns of the S&P 500 and the tech-oriented Nasdaq.
Having endured volatility at the start of the Iran war, the equity market’s focus appears to be the anticipated high returns of the tech sector even as the Dow Jones Industrial Average has slipped by 5.5% since the first week of August.
Since the start of the year, our equity performance index, which factors in volatility, shows a series of lower lows and lower highs interrupted only by the initial shock of war, with the highs reflecting optimism surrounding AI and the lows reflecting changing oil prices.
What looks to be the formation of a downtrend of still-elevated returns this year might suggest a lowering of confidence in the sustainability of those returns.
Money market
In the money market, the uncertainty over monetary policy appears to have been replaced by rational expectations of higher rates necessary to combat the inflationary pressures of tariffs and energy shortages.
The overnight federal funds rate is catching up to commercial paper, with the forward markets anticipating short-term rates approaching 5% within the next 12 months.
The 25 basis-point increase in the effective federal funds rate to 3.88%, in the middle of the Fed’s 3.75% to 4.0% target range, will increase the cost of short-term borrowing necessary for the day-to-day operation of commercial activity.
Additional rate hikes will further inhibit business spending and employment, producing the drop in consumer spending and business expenditures needed to tame inflation.
Bond market
The increased recognition of untethered government debt squeezing out private investment is now pushing long-term interest rates higher in both the private and public sectors.
The benchmark 10-year Treasury yield has jumped to 5.20%, with the 30-year reaching late 1990s-early 2000s rates of nearly 5.50%.
Add to that the wait-and-see stance of policymakers, the increase in inflation before the war and then six months of energy shocks.
The loss of confidence in both the fiscal and monetary authorities caused investors to demand higher returns on their purchases of private and public debt offerings.
The result is higher interest rates since the war began, with no credible plan to address either the debt or fuel shortages.
The rise in interest rates has been responsible for the largest contribution to the tightening of financial conditions, with increased volatility becoming a factor only in the past two days.
The bond market has always been more attuned to expectations of economic growth and to policy risk. The recent increase in the front end of the yield curve is in anticipation of further monetary policy tightening that will raise the cost of short-term borrowing.
The dramatic increase in long-term interest rates and the flattening of the curve, from 2 years out to 30, points to the risk of an oversupply of debt meeting insufficient demand for bonds that now have become riskier.
That is forcing interest rates to move higher to compensate investors for taking on the risk of holding securities with the likelihood of deflated returns.
The takeaway
The long-awaited move to tighten financial conditions has begun, with the Fed at the start of a campaign to dissuade households and businesses from spending and investing by raising the cost of credit.
Because financial conditions remain somewhat accommodative, this gives the Fed more leeway to hike rates until inflation is brought under control.
As the bond market is saying, the era of low interest rates is over.
