Financial conditions in the United States continue to be highly favorable for investment despite the recent rise in some asset classes, according to a new measure from RSM US.
Introducing a proprietary measure of financial conditions in the United States from RSM US.
With the Federal Reserve maintaining its low interest rate policy to encourage economic activity, the risk being priced into financial assets remains near its lowest level in years, exceeding 95% of the weeks since 1995, according to the RSM US Financial Conditions Index.
Such a favorable environment for investment will be essential if the U.S. is to stage a full recovery from the economic disruptions inflicted by the pandemic and the trade war that preceded it.
As our analysis shows, these high levels of financial accommodation typically occur in the aftermath of catastrophic shocks, with the Federal Reserve acting aggressively to avert an economic collapse.
Central bankers have long recognized that monetary policy is transmitted to the economy through the financial sector. If an inordinate amount of risk is priced into financial assets because of a financial shock, the cost of both day-to-day commercial financing and long-term investment increases, reducing commercial activity and limiting economic growth.
But if the monetary authorities were to maintain liquidity and the viability of the commercial markets and reduce the cost of investment by lowering long-term interest rates, then economic activity can regain its footing. Borrowing and lending can then resume their normal pattern, growing the economy as confidence returns.
In our proprietary financial conditions index, a positive value indicates an accommodative environment for commercial activity and investment. A negative value indicates increased risk of borrowing and tighter borrowing requirements.
The index is constructed as a Z-score, the number of standard deviations away from normal levels of risk and behavior, where zero is defined as normal.
At its current level, financial conditions are 1.3 standard deviations above what would normally be expected, indicating reduced levels of risk being priced into financial assets. Given this accommodative financial environment, we can expect economic growth in the coming quarters.
Yet this high level of accommodation has many commentators concerned about runaway inflation and calling for the Fed to reverse course. Our index rarely remains above current levels, with those high levels suggesting possible bubbles particularly in the housing and equity markets.
But those bubbles are supply-side issues. The housing market has not been able to keep up with the demand for single-family residences, and equities have surged as investors have searched for higher returns.
We expect the Fed to keep short-term interest rates at the zero bound until full employment is reached, while gradually releasing its downward pressure on long-term rates.
Our financial conditions index is at its core a risk indicator and has moved substantially lower after economic shocks. For instance, the financial crisis in 2008-09 created a 12-standard deviation shock. That was followed in quick succession by a two-standard deviation spillover shock from the European debt crisis in 2010-12, a shock of more than one standard deviation during the commodity price collapse in 2014-16, and then shock of the trade war and global manufacturing recession starting in 2018.
In the sections that follow, we will briefly explain the asset prices used to construct our composite financial conditions index, showing how they move in concert during times of stress and recovery. And then we’ll discuss our monitoring of asset-price bubbles.
The money market
The money market finances the day-to-day operation of commercial activity. As we have seen during times of stress—the dot.com bust of 2001, the global financial crisis of 2008-09 and, most recently, the pandemic in 2020—money market spreads will balloon to extraordinary levels as default risk increases. Borrowing becomes prohibitive and the markets freeze up.
Central banks have responded to these shocks by flooding the market with liquidity, but not before short-term interest rates for commercial transactions have skyrocketed compared to benchmark (risk-free) interest rates.
We measure the interest rate spreads in three ways:
- The commercial paper rate (within-a-year domestic transactions) and the benchmark three-month Treasury bill interest rate.
- The so-called Ted spread between the London-based three-month LIBOR (international and domestic transactions) and the three-month Treasury bill.
- The three-month LIBOR versus the OIS (overnight indexed swap) rate, which is a virtually riskless proxy for the federal funds rate and which has gained importance since its introduction in 2006.
Our money market component of the financial conditions index is an average of the commercial paper spread, the Ted spread and the LIBOR/OIS spread. Those spreads tend to rise along with perceptions of the risk of an economic downturn and impending corporate default.
The bond market
Bond market spreads contain elements of expectations for monetary policy, inflation, economic growth and corporate risk. This remains so even as bond yields have been compressed over the decades, with short-term rates moving closer to zero and longer-term securities dropping below 1% last year.
Given this consistency, we have constructed the bond market component of our financial conditions index, giving equal weight to Treasury yield-curve spreads, credit spreads and Treasury market volatility.
We use two yield-curve spreads. The first is the 10-year Treasury yield less the three-month T-bill rate, which measures perceptions of the potential long-term growth of the economy. The larger the spread, the more likely that economic growth and inflation can support higher interest rates over the life of the bond.
The second is the spread between five-year Treasury bonds and two-year Treasury bonds. Because two-year Treasury yields encompass expectations of the path of the federal funds rate over the next two years, the five-year/two-year spread encompasses medium-term expectations of growth compared to changes in monetary policy.
Credit spreads encompass perceptions of the risk of an economic slowdown and corporate default. Credit spreads of investment-grade and higher-risk (high-yield) corporations tend to increase in late-cycle runups to recessions before receding again as the recovery develops.
We look at the yield spread between so-called investment-grade corporate (Baa rated) bonds and 10-year Treasury bonds. For riskier assets, we look at the yield spread between so-called high-yield corporate bonds and 10-year Treasury bonds.
As with yield spreads late in the business cycle, bond market volatility has tended to increase in the runup to a recession as investors anticipate the eventual turn in the business cycle and the increased risk of default. We have created an index of volatility based on the 20-day standard deviation of two-year, five-year, 10-year and 30-year bond yields.
Because of the compression of bond yields, you would expect the 20-day standard deviation to have decreased over time, particularly in the decade-long era of low-for-long interest rate policy of the Federal Reserve after the financial crisis.
The equity market
Despite its prominence in the news, the equity market is not the economy. With the near-zero return on fixed income investments, investors are looking to equities for return, and the equity market has reflected this speculative interest among investors.
Because interest rates have been so low for so long, the stock market has been on a tear since the global financial crisis.
Nevertheless, and to the extent that equity prices are an indicator of perceptions of corporate profits, the stock market is an indication of confidence in the economy. When the pandemic caused an economic shutdown, it was the stock market crash that caught everyone’s attention, not the efforts of the central bankers to keep the commercial sector functioning or to foster the investment needed to keep the economy growing.
Because interest rates have been so low for so long, the stock market has been on a tear during the recovery from the global financial crisis. As such, we are using two measures of equity market performance to determine its contribution to composite financial conditions.
The first is what we term its directional return, which we define as the ratio of the current rate of return of the S&P 500 relative to the 52-week moving average of those yearly returns. Our analysis suggests that this directional return diminishes as the business cycle enters its final phase, crashes during the recession, and then shoots back up as the recovery takes hold.
The current reading remains elevated, while its deceleration toward its long-run average suggests that the initial surge in equity prices was unsustainable.
The second indicator is the traditional measure of stock market risk, the 30-day volatility of the S&P 500 index. As with the bond market, equity market volatility moderated during the 2010-17 recovery and then began to move higher in the late stages of the business cycle and the turbulence created by the trade war.
Volatility has moderated since the 2020 market crash, with short-term movements likely to reflect political events and perceptions of changes in monetary policy.
Asset bubble monitor
We have created an ancillary index to monitor the creation of asset bubbles in the housing, technology and financial sectors. Our index suggests the presence of asset bubbles both because of excess demand (like the late-1990s technology bubble and the surge in housing during the 2000s) and because of low-for-long interest rates after recessions.
The recent housing and tech bubbles are both attributable to the peculiar circumstances of the pandemic.
The tech bubble of the 1990s was two-sided, pushing the share prices of everything tech to unwarranted levels while improving productivity in the U.S. economy.
The housing boom of the 2000s was an overreach that ended in the collapse of the global financial system. In response, the advent of low-for-long interest rates led to a surplus of cash, shrinking demand for fixed-income securities and a surge in equity prices.
This latest episode has elements of all three bubbles, leading to calls for the Federal Reserve to remove its accommodation and restore balance to markets. But the housing and tech bubbles are both attributable to the peculiar circumstances of the pandemic (the need to work at home and the desire for single-family homes). The demand for tech will certainly increase productivity, but the housing market remains troubling in terms of affordability.
We expect the low-for-long interest rate regime to gradually fade away, as it did in the years after the global financial crisis.
