The recent decline in financial conditions eased in recent weeks as the markets moved from pricing in the risk of holding assets at a moment of deepening geopolitical stress to one of resignation.
The RSM US Financial Conditions Index remains more than 0.2 standard deviations below normal.
In our estimation, the likelihood of a protracted conflict in Eastern Europe and higher oil prices as Chinese lockdowns end later this spring will almost certainly continue to weigh on financial conditions as corporate earnings start to be published this week.
This potent combination should continue to act as a drag on financial conditions, risk appetite and overall economic activity even as hiring and capital expenditures continue at robust levels.
The RSM US Financial Conditions Index remains more than 0.2 standard deviations below normal. This is an indication that investors are requiring additional compensation for the risk of lending and the increased cost of investing in an environment of heightened uncertainty.
A few weeks ago, our index had reached a full standard deviation of excessive risk, a reflection of the level of volatility in the financial and commodity markets.
The RSM US Financial Conditions Index is a composite measure of the degree of risk priced into financial assets in the money, bond and equity markets.
Central bankers now accept that monetary policy is transmitted to the economy through financial conditions. Their missions include a commitment to maintaining a stable and accommodative investment climate—which is necessary for economic growth—in addition to their traditional roles of price stability and full employment.
Over the past two years, the level of financial accommodation has reached as low as 6 standard deviations below normal at the depth of the pandemic. It then quickly rebounded to 1.7 standard deviations above normal as money was pumped into the economy and vaccinations allowed for more normal levels of interaction.
Over the past 30 weeks, however, the withdrawal of income support and the flood of coronavirus variants reduced that level of perceived normalcy, now capped off by Russia’s invasion of Ukraine and its effect on the energy and commodity markets.
Money markets
Money markets are crucial to the day-to-day operations of the business community, with spreads between commercial interest rates and those of government securities an indication of the willingness to take on risk.
During past episodes of economic stress, the so-called Ted spread between the three-month Libor rates and the three-month Treasury bill rates spiked 20 times higher than average during the 2008-09 financial crisis, with the Fed taking on the role of lender of last resort.
During the 2020 pandemic shutdown, the spread was seven times higher. At its highest point so far during the Ukraine crisis, the Ted spread spiked only two times higher than what would normally be expected.
There are new sets of instruments and facilities created in the wake of the money market freeze-up of the 2008-09 financial crisis.
The FRA-OIS spread (forward rate agreement less the overnight index swap rate) is a hedging device based on expectations of the direction of the Libor-OIS spread. In this latest episode of stress, the FRA-OIS spread quickly spiked higher during the buildup of Russian troops, and then receded a week ahead of the Libor-OIS spread as some semblance of a stalemate in Ukraine became more likely.
There is nevertheless an inordinate amount of stress remaining in the money markets.
And this reticence among commercial financing interests to borrow or to lend has resulted in an excess of cash sloshing around the money markets. After the experience of the financial crisis, the Federal Reserve now operates a facility for parking that cash, earning an “award” rate of 5 basis points as of June last year that has now increased to 30 basis points in this latest crisis. According to the Fed, about $1.6 trillion is invested overnight in this new facility.
We would expect the amount of cash to retreat if and when the geopolitical risk is drained from the markets.
Bond markets
The bond market is in the midst of a seven-month sell-off in which 10-year Treasury yields have increased from 1.2% to 2.4%. This is one in a series of selloffs that have characterized the otherwise secular downtrend of long-term interest rates since the 1980s.
During the recovery from the 2008-09 financial crisis, 10-year yields consistently spiked higher:
- By 120 basis points during the spillover from the 2010-11 European debt crisis and the 2011 U.S. debt ceiling crisis.
- By 130 points. during the 2013 so-called taper tantrum.
- By 75 points during the 2016 inflation scare brought on by the Trump administration’s plans for tax cuts and infrastructure spending.
- By 90 points since the end of 2021 as inflation accelerated and war in Ukraine became obvious.
A 2013 analysis by the Federal Reserve Bank of New York identified whether the yield changes were better explained by expectations of higher short-term rates or by investors demanding greater compensation for the risk of holding long-term Treasury securities.
For instance, the FRBNY analysis found that the increased risk for holding a long-term asset (the term premium) was responsible for the selloffs in the 2010-11 debt crises and the 2013 taper tantrum.
Our analysis suggests that expectations of higher short-term rates have been the predominant factor in both the 2016 bond market selloff and the most recent selloff.
The current selloff has resulted in higher volatility in the Treasury market and an increase in the cost of funding of private debt. Investment grade yields have increased more than 100 basis points during the first three months of the year.
Equity markets
The S&P 500 index, which by the first week of March had lost 13% of its value relative to its end of December peak, has recovered somewhat and is now down by 5% in the same time period.
That implies an increase in volatility but remains far below the instability of the financial crisis or the pandemic.
Because most investors require both a stable environment and an adequate rate of return, this current episode might not lend itself to attracting additional interest. Because of this and the market’s performance in the past year, the equity market is underperforming by 0.7 standard deviations.
Still, the stock market has been the only game in town for investors seeking returns and despite its recent performance, a buy-and-hold strategy would have generated a 13% return over the past 12 months. Whether it holds onto those gains will depend on the war and the impact of Federal Reserve policy on economic growth.
