As this latest episode of banking distress makes clear, the health of the U.S. economy depends on the health of the financial sector. Even if a business seems far removed from Wall Street, trends in the financial markets have important implications on that company’s fiscal health and operations.
U.S. economic history illustrates this connection—for better or worse.
In the 1930s, the public lost confidence in the banks, creating a series of bank runs that resulted in the Great Depression. In 2008, the inability of financial stalwarts Bear Stearns and Lehman Brothers to fulfill their obligations led to the freezing of the global financial system and the Great Recession.
We find ourselves experiencing familiar circumstances in 2023, with the closing of three U.S. regional banks and the near collapse of Credit Suisse, a systemically important financial institution that plays a substantial role in worldwide banking.
It is highly likely as the deposits of households and businesses shift from small and midsize banks to money funds and/or larger banks following the recent market disruption, a period of tighter lending standards will follow. Banks of all sizes will adjust to the post-crisis environment, and capital to meet payrolls and fund expansion will become scarcer and more costly.
The financial channel that comprises bank lending to businesses is set to become a bigger economic headwind for those businesses, as the rising cost of credit, increased regulatory standards, and a reduced deposit base will lead to a net reduction in commercial credit for some time.
What to monitor?
There is a host of financial indicators that will affect the ability of your business to borrow from local banks and meet payroll or short-term expense requirements. The RSM economics team monitors more than 75 different risk metrics across the fixed income, currencies, commodities, equities and assets markets.
Our RSM US Financial Conditions Index summarizes the market action of those indicators. Financial indices are used by central banks to set policy; by financial institutions to manage portfolios and risk; and by businesses large and small to allocate capital.
Our index is a composite measure of risk (or accommodation) priced into the equity, money and bond markets. Negative index values imply excessive levels of financial market volatility and stress, and therefore a decreased willingness to borrow or lend. Positive values imply increased levels of financial accommodation necessary for investment and economic growth.
As of March 16, the RSM US Financial Conditions Index showed increased levels of risk in the financial markets equal to 1.5 standard deviations below zero. Zero is defined as normal conditions of risk and volatility expected to be priced into financial assets.
Note a reading approaching 2 standard deviations is considered statistically different from normal conditions; it occurs during periods of severe crisis. The current reading is nearing that point.
The following charts and short descriptions provide a picture of what we consider the most important market indicators and their long-term trends.
We start with the money market, through which the Federal Reserve’s monetary policy is transmitted to the bond (fixed income) market and the economy as a whole via the federal funds rate, the rate at which commercial banks borrow and lend their excess reserves overnight. We end with the equity markets, which despite notoriety in the press, might be considered a more reactive indicator than the fixed-income markets, but has undeniably been the final straw in previous financial and economic upheavals.
The money markets generally run smoothly until a crisis occurs. In the current period, short-term interest rates have been reacting to the flight to cash, with investors buying up anything that offers the safety of cash but includes a return. That demand for cash is perhaps the best indicator of the money market’s assessment of risk.
The Fed funds rate and short-term commercial interest rates
Interest rates are determined first and foremost by the direction of monetary policy and the Fed’s setting of its overnight Fed funds rate. Because of its proximity to overnight rates, three-month borrowing typically reacts directly to the funds rate or to the markets assessment of where Fed policy is heading.
This can be seen in the chart below, which shows the recent stickiness of three-month rates available in the interbank market during times of rapid shifts in Fed policy. Note that because of the upheaval in the London interbank market, the Fed is shifting attention to the system overnight financing rate (SOFR) market.
Measuring risk in the money markets—The FRA-OIS spread
Historically, we were able to assess risk in the money markets by measuring the interest-rate difference between unsecured inter-bank rates that are available to commercial borrowers and include a premium for credit risk, and risk-free Treasury-bill rates. Because of the most recent flight to cash, those spreads have become distorted, with the funds rate and Treasury bill rates constant while interbank rates have declined.
Recent attention is focused on the difference between unsecured floating rate agreements and the overnight indexed swap rate, which is keyed to the Fed funds rate. The effect of the banking crisis is seen in the sudden reversal of the forward rate agreement-overnight index swap (FRA-OIS) spread from confidence in the outcome of Fed rate hikes to the potential of instability and greater risk.
The U.S. bond market is unique in that Treasury bonds are the benchmark for global trade and financial transactions, while the U.S. corporate market replaces banks as a means of financing for large entities.
Treasury bond yields and expectations of inflation
You would expect short-term bond yields to be directly attuned to expectations for inflation and the expected path of the Fed funds rate. You would also expect longer-term bond yields to include a risk (or term) premium for holding that security over the life of the bond, with inflation unlikely to remain constant over that extended period.
The latest period is best characterized as abnormally high inflation. And with the Fed having to quickly react to crisis after crisis, the yield on 10-year bonds has increasingly become dependent of expectations for inflation.
Treasury yield curve and the risk of recession
The shape of the Treasury yield curve is a proxy for the direction of the economy. The normal shape of the yield curve is upward sloping with long-term rates higher than short-term rates. That is, economic growth can support higher long-term interest rates relative to short-term rates
In contrast, short-term bond yields increase in response to monetary tightening and Fed funds rate hikes, while long-term rates drop in response to expectations of lower growth. This results in the shape of the yield curve turning downward, known as an inverted yield curve.
Yield curve inversions often precede an economic slowdown by several months. At present, the spread between 10-year bond yields and short-term interest rates is the most severe since the 1980s era of double-dip recessions. This is at once a great concern and a sign that the Fed’s tightening of monetary policy in response to the 2022-23 inflation shock will achieve its objective of lowered demand.
Treasury market volatility—The MOVE index
Because the investment decision process includes the requirement of market stability and because of the importance of the Treasury market to international commercial activity, volatility in the Treasury market is a component of the RSM financial conditions index.
The Merrill Lynch Option Volatility Estimate index is a publicly available index of stability in the Treasury market. As we show, the MOVE index is now at its highest level of instability since the 2008 financial crisis, far exceeding the 2020 spike during the health crisis. We can expect this volatility to continue as long as the uncertainty around the banking crisis continues.
The U.S. corporate bond market
In most economies, private capital is acquired from banks. In the U.S., larger corporations have access to the corporate bond market, with the benefit of indirect subsidies provided by the Fed’s quantitative easing program, which kept interest rates low and stable over the last decade.
Because of the risk of corporate default, you would expect corporate borrowing to include a risk premium over the yield of guaranteed Treasury bonds. As we show, during periods of severe economic distress, lenders will require greater compensations for holding that credit spread.
During 2022, investors sought the higher returns of corporate bonds. The risk of bank failures in recent weeks, however, is now working in the opposite direction, with signs of corporate credit spread widening.
Because of its ease of access and its press coverage, the equity market can be most subject to short-term speculative and reactive pressures. Nevertheless, equity market crashes have set off the last three financial crises and economic downturns.
Valuation of the equity market
The equity market has long-since abandoned any sense of valuation over the long run, which suggests the usefulness of monitoring the S&P 500 today relative to its recent average performance. We show the one-year moving average as an example of a cross-over strategy, with changes in equity market positions taking place when the daily index moves below its moving average.
For instance, in the current period, the S&P 500 peaked in the first week of 2022, losing 19% of its value in the 15 months since then. A cross-over strategy would have signaled a change in position in the spring of 2022 that would have limited the losses.
Volatility in the equity market
Equity market volatility is commonly measured by the VIX index, maintained by the Chicago Board of Trade and available on Bloomberg on a minute-by-minute basis. The index is based on options on the S&P 500 index and as such can be quite noisy.
Despite the upheaval in the banking industry, the VIX index has just recently risen to its pre-pandemic average.
30-day volatility in the S&P 500
Equity market volatility can also be measured by the 30-day standard deviation of the S&P 500 index.
Note that this is a lagging variable but gives a better sense of the trend in volatility. In recent weeks, the 30-day volatility has in fact been trending lower.