After nearly two years of extreme accommodation in the financial markets, the RSM US Financial Conditions index stands at 0.96 standard deviations above neutral—a decline from the elevated levels during the pandemic and a sign that markets are starting to price in more risk.
A normalization of financial conditions from unsustainable levels of the past two years was to be expected and is in order.
The index’s more modest level almost certainly reflects the Federal Reserve’s decision to normalize its monetary policy and the fading of the fiscal support that Congress provided during the worst of the pandemic.
Investors have priced in three full rate hikes this year, with a 90% probability of a fourth. And with a growing number of Fed policymakers looking to draw down the central bank’s $8.7 trillion balance sheet starting this spring, a normalization of financial conditions from unsustainable levels was to be expected and is in order.
The omicron variant
But the omicron variant has added a new level of uncertainty to the outlook. Although a resurgence in COVID-19 cases has yet to materially affect the labor market, the resurgence has dampened spending and is the primary reason why we have reduced our first-quarter estimate of growth in gross domestic product to 1.7%.
This decline in domestic financial conditions is leading to increased volatility in financial markets and contributed to the 60% drop in the RSM index from mid-November to mid-December.
The index is a composite measure of risk (or accommodation) priced into financial assets in the money, bond and equity markets.
The omicron variant has added a new level of uncertainty to the outlook.
Positive values indicate a financial climate conducive to borrowing and lending, and the potential for economic growth. Values around zero indicate levels of risk normally priced into financial assets.
Negative values indicate increased risk and increased compensation required by holders of that risk, with higher costs curbing investment and future growth.
Equity market returns began moderating in November. Pricing in the money markets has become consistent now that the Treasury Department is once again issuing debt, and bond yields have moved higher compared to still low Treasury bill rates.
Overall, the investment climate remains accommodative. And despite the less-than-perfect December jobs and inflation reports, corporate profits are expected to remain elevated, suggesting continued economic growth.
End of low-for-long era
Even if the spread of the omicron variant were to moderate growth in the first quarter, the economy has rebounded so quickly from the depths of the economic shutdown that it’s time for interest rates to begin to normalize after a decade of crisis management.
That implies what will eventually become the end of low-for-long money market rates, repressed long-term bond yields and—because of a wider range of yield outcomes—the reintroduction of risk into fixed-income assets.
To our thinking, increases in volatility and moderation of speculative-asset returns at this stage would be a welcome sign of normal market behavior, which includes the potential for loss.
According to surveys reported in the minutes of the Federal Reserve’s December meeting, financial market participants were generally not anticipating significant strains in money market conditions now that Congress has avoided default on the nation’s debt.
And as reported by Bloomberg, the Fed has established facilities to provide the smooth operation of the repo markets. That should avoid issues that arose during the drawdown of securities acquired during quantitative easing operations after the financial crisis.
The bond market
As for the bond market, the minutes of the Fed’s December policy meeting found that the “omicron variant reportedly drove safe-haven flows into sovereign bonds, pushing term premiums lower.”
If that were indeed the case, then the 35 to 40 basis-point increase in the 10-year yields since their December low most likely reflects confidence in the ability of the economy—and the financial sector at a minimum—to move beyond this latest surge in infections.
And though the Fed’s immediate reason for increasing interest rates might be the increase in inflation, we would argue that the higher rates signify an economy able to support higher returns on investment. This would coincide with the positive medium and long-term effect of infrastructure spending on potential economic growth.
The housing market
The increase in bond yields also implies reduced upward pressure on house prices as the cost of holding mortgage debt increases. This is reflected in the return to normal levels of excessive price levels in some assets like housing and technology stocks.
Recall that the bursting of an asset bubble can have disastrous consequences for the financial sector—and a drag on the economy—as in the dot-com bust in 2001 and the runup to the financial crisis.
The pandemic-induced rate of change in the demand for work-at-home technology products and single-family houses—and the availability of extremely low interest rates to finance that demand—appears to be reaching a new equilibrium.
But as with predicting the course of the coronavirus variants, all this relies on assumptions of a successful rollout of a global vaccination program.
In December, the Texas Children’s Hospital and Baylor College of Medicine announced authorization of its protein subunit COVID-19 vaccine, to be launched in India with other underserved countries to follow.
And in terms of the domestic economy, the increased health and productivity of the labor force will depend in part on the rollout of additional infrastructure programs and the availability of labor.