The RSM US Financial Conditions Index turned positive six weeks ago, with reduced volatility in the markets allowing for normal levels of risk.
The rebound in equity markets, and specifically, the performance of the tech sector, suggests that investors since May have simply shrugged off the imposition of tariffs, and it is as if the 12-day war in the Middle East, which included American involvement, never really happened.
Our index measures the level of risk (or accommodation) in the equity, money and bond markets and combines them to assess the overall propensity to invest.
Negative values of the index imply excessive levels of risk, and an increased cost for capital and business operations. Positive values imply a climate of accommodation for investment, which implies lower operating costs leading to increased profit margins and economic growth.
This latest increase in financial conditions is a product of reduced levels of volatility in both the equity and bond markets, and a money market able to work around the upcoming debt ceiling debate. All of this has put overall financial conditions at 0.25 standard deviations above zero, which signifies normal levels of risk and returns.
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That improvement is one of the reasons why, although we expect growth to slow this year, the American economy will avoid a recession.
That being said, we are always careful remind all that gains in the equity market do not necessarily translate into economic growth and that the normalization of financial conditions because of the recovery in the equity market should not by itself suggest normalcy in all markets.
The markets are dealing with pervasive uncertainty, and there are geopolitical factors that should not be ignored.
For instance, the U.S. bond market is in a selloff among long-duration bonds. The steepening the 30-year/5-year yield curve is a product of investors demanding greater returns to compensate for the increase in duration risk.
Concerns over increased inflation and government dysfunction are affecting 10-year bond yields as well. And at a time of rising expectations in the bond market that the Federal Reserve will resume cutting interest rates, increased risk factors are pushing the term premium for holding 10-year Treasury bonds higher.
The result of this push and pull has been a standoff, with 10-year yields range-trading around 4,4%.
Adding to the strain in the bond market is the dollar’s sudden loss of value. The so-called sell-U.S. trade, which is a function of expectations on fiscal policy and inflation, is pushing the dollar lower, reducing the returns for dollar-denominated securities.
The dollar’s latest drop is one in a series of dips in the dollar’s value after its most recent peak in 2022.
Ironically, the dollar’s success in recent years has pushed trading partners among the emerging economies to look for non-dollar transactions. This would be especially important for nations dependent on foreign sources of oil and foodstuffs, which are priced in dollars.
The takeaway
The improvement in U.S financial conditions is because of the drop in volatility as financial markets settled into complacency after the initial tariff shock.
The result has been a bond market in the midst of a long-duration selloff, while the risk premium for holding 10-year bonds is increasing.
There are geopolitical factors that should not be ignored as well as the threat of higher inflation that is likely to become a drag on financial conditions and economic growth.
