After three months of what seemed to be disregard for the direction of Federal Reserve policy, the money markets are once more expecting a tightening of financial conditions.
But it took a banking crisis to get there. The bond and credit markets in our estimation are pricing in a recession later this year.
With our RSM US Financial Conditions Index standing at 1.4 standard deviations below neutral, which implies that financial activity is a notable drag on overall economic activity, it is likely that more restrictive monetary policy on top of a tightening of financial conditions will lead to a near-term tipping point in the economy.
That is why we have not altered our baseline forecast of a 65% probability of a Fed-induced recession that would start in the second half of the year following the publication of our forecast last November.
For the first time since the end of last year, the money market component of our financial conditions index has been negative in the last two weeks.
Prices in the money market now suggest increased levels of risk being priced into short-term lending and the tightening of overall financial conditions that was missing until the collapse of Silicon Valley Bank and Credit Suisse.
Community and regional banks are the backbone of the real economy, and tighter lending will lead to slower overall economic activity and higher unemployment.
Community and regional banks are the backbone of the real economy, and tighter lending will lead to slower overall economic activity and higher unemployment.
Although probably too early to call, market action in the money markets might also signal a growing preference for outright cash among investors and banks.
In any case, the sudden increase in money market spreads suggests reduced liquidity in the commercial lending sector and a further tightening of financial conditions that should help apply the brakes on the economy and the eventual reduction in inflation.
Asset markets have been signaling increased risk and tighter financial conditions throughout last year.
Inflation pressures had become overwhelming, and it was obvious that that the Federal Reserve would do all it could to counter the food and energy shocks and the unique circumstances that brought about the high demand for goods and then services.
The Fed’s tools for conducting monetary policy, with respect to price stability, are largely limited to its hiking of short-term interest rates, forward guidance and the reduction of its balance sheet.
While the Fed explicitly outlines its views on the direction of the economy and its intent to affect financial conditions, that is no guarantee that the markets will follow. The behavior of the credit markets this year is a case study.
Short-term securities
The current rate-hike cycle began a year ago. As expected, those rate hikes were followed by increases in credit spreads, which are the difference between private lending rates and the guarantee of risk-free government securities. The markets were pricing in the risk of an economic slowdown.
That trend lasted until mid-to-late last year, when investors were attracted to higher returns available in the both the corporate bond market and the short-term lending market.
Inflation became more persistent than expected and as the debt-ceiling default approached, preference for short-term securities increased.
It is our contention that the increased demand for short-term securities—you could borrow at the federal funds rate and invest in higher-yielding money markets—pushed down the rates of private lending compared to the increases in the Fed’s policy rate from late last year until March.
But the period of high demand for short-term securities looks to have been truncated by the banking crisis, with investor demand now centered on protecting cash balances.
Model-based expectations
The recent noise in long-term interest rates fits the pattern modeled by the New York Fed. The ACM model finds that interest rates are determined by two factors:
- Expectations of the path of short-term rates as set by the Federal Reserve’s overnight policy rate.
- A term premium required by investors to compensate for the risk of holding a bond over its maturity.
The balance between short-term rate expectations and the term premium changes over time. In recent years, monetary policy has become the predominant factor as the economy moved from disinflation to a more normal environment of price increases and the Fed’s response to those increases.
But last year, the Fed had to respond to the combination of a red-hot economy and the energy-price shock and pushed the federal funds rate 475 basis points higher in only 12 months. Ten-year bond yields followed expectations of a tighter Fed policy.
The expected path for Fed policy stalled early this year, however, and remains indecisive as speculation grows over the timing of an eventual pause in Fed rate hikes and a slowdown in economic activity.
The end result has been an increase in bond market volatility, with the effect of a tightening of financial conditions.
The bond market and inflation expectations
Long-term interest rates are determined by both expectations for inflation.
Inflation expectations and bond yields were in a secular decline until the inflation shock last year. The effect of the shock appears to have peaked late last year as the Fed’s rate hikes began to take hold.
Expectations for inflation in 10 years has bounced within 3.4% and 3.6% over the past five weeks, while 10-year Treasury bonds have traded within an equally noisy 3.4% and 3.9% as uncertainty over the banking crisis increased.
The bond market and financial conditions
Monetary policy is transmitted to the real economy through the federal funds rate. If the Fed lowers the funds rate, that lowers the cost of credit and the level of risk in the investment decision-making process.
Conversely, if the Fed hikes the funds rate, that works to increase the cost of capital and acts to slow an overheating economy and the rate of inflation.
The RSM US Financial Conditions Index is a composite measure of the level of risk or accommodation in the equity, money and bond markets. But as we show below, the transmission of monetary policy flows most directly through the bond market, with its implicit assessments of the direction of economic growth, credit risk and market stability the most important aspects of overall financial conditions.
As of March 23, the bond market is signaling further stress in the financial markets, with the focus shifting to the reaction of the Fed should the banking crisis continue at this time of continued inflationary pressures.
