Despite a strong bounce in U.S. financial markets following better-than-anticipated inflation data for October, financial conditions remain tight.
Financial conditions in the United States are more than two standard deviations below normal, according to the RSM US Financial Conditions Index.
The risk to the economic outlook has not abated after one month of encouraging consumer price index data. Central banks continue to increase the cost of credit to restore price stability, leading to tighter financial conditions around the world.
The United States is no exception. Financial conditions in the United States are more than two standard deviations below normal, implying excessive volatility and risk being priced into securities and signaling slower growth, according to our proprietary RSM US Financial Conditions Index.
To understand these rapidly changing financial conditions and what awaits, a series of snapshots shows why these forces won’t be changing anytime soon.
Uncertainty is rising …
Rising geopolitical and economic uncertainty is showing up in asset prices. These risks include financial tightening following the surge in inflation, geopolitical upheaval and the potential fallout from a renewed debt-ceiling debate in Congress.
… which will cool business investment …
These risks will, in turn, lead to less borrowing and lending, and, ultimately, reduced business investment.
… but not investments that improve productivity
Still, businesses have continued to make targeted investments in productivity as seen in the sustained investment in equipment and intellectual property. This is most likely a byproduct of the shortage of labor and the need for self-sufficiency after the supply chain disruptions.
But not all areas of investment have held up so well. Residential investment, for example, has tailed off as mortgage rates have risen.
Still, firms face rising short-term rates …
The forceful change in Federal Reserve policy has resulted in increased bond market volatility and higher interest rates, particularly among shorter-maturity Treasury bonds.
… as well as higher long-term rates
The dramatic changes in monetary policy stemming from the pandemic and now the inflation shock have been the major factors in setting the 10-year Treasury bond yield.
We expect the federal funds rate to exceed 5% over the next two to three months, and for 10-year yields to end the year at 4.25%. Rising inflation will result in 10-year yields trading in the range of 4% to 5%.
Rising volatility is showing up in the equity markets …
The dramatic shift in monetary policy is increasing the volatility of equity markets. Both S&P 500 and Nasdaq have fallen into a bear market this year.
Such steep losses, which are even worse in the more speculative areas of the market, as well as higher interest rates, will send many investors to the safety of the 4% returns available in the bond market.
… the crypto markets …
Investments in cryptocurrencies plunged, with Bitcoin losses of 53% last year and 70% this year, not to mention the collapse of FTX and its affiliated companies.
… and the bond market. Little has been immune.
The bond market has also experienced a sell-off this year. As of early November, five-year Treasury yields had increased by 265 basis points since March, while 10-year yields had increased by 240 basis points.
Is a recession coming? Look at the yield curve.
The bond market sell-off, particularly at the front end of the yield curve, can be attributed to the Fed’s effort to stabilize prices by increasing the cost of credit. Interest rates at the front end of the curve are most responsive to perceived changes in monetary policy. By mid-November, two-year yields were 4.7% and five-year yields were 4.3%, with additional hikes in the overnight federal funds rate. As is typical at the end of business cycles when monetary policy pivots from accommodation to tightening, short-term interest rates are higher than 10-year yields at 4.1%.
With inflation at 8% and with nominal yields still relatively low, the entire real, or inflation-adjusted, yield curve remains negative. That implies that borrowing at current rates will be repaid in deflated dollars.
The yield curve is showing higher rates …
After years of near-zero interest rates, both monetary policy and interest rates have been shocked into returning to what were once-normal levels. The dramatic change has pushed both the overnight federal funds rate and the 10-year benchmark interest rate to 4%.
We anticipate the Fed to push the rate to at least 5% with 10-year yields moving higher until the depth of the slowdown becomes apparent.
…and a 10-year rate that mirrors inflation
Over time, 10-year bond yields have responded to changes in the market perception of inflation; the relationship has become virtually identical in recent trading.
Long-term inflation expectations remain in check…
Measuring inflation expectations can be art more than science. University of Michigan surveys suggest that the public thinks inflation will be less than 3% over the next five to 10 years. The Philadelphia Fed’s Aruoba model of inflation expectations shows inflation of 3.1% in the next year and then retreating to 2.3% in 10 years.
… even as premiums rise for taking on risk
For now, 10-year bond yields are responding to expectations of monetary policy, analysis by the Fed shows.
But long-term interest rates include a risk component, known as the term premium, that encompasses the risk of an event occurring within the life of the bond.
In our view, its slightly negative value suggests perceptions of increasing risk of government default and illiquidity in the bond market, likely associated with the potential for the debt ceiling debate to turn toxic.
Bond market: Part 1
The bond market is showing the first signs of deterioration. Treasury auctions with a ratio of two bids received for every bond sold—the so-called bid-to-cover ratio—are considered healthy. But in recent auctions, the ratio for 10-year bonds has been slipping. Although the decline is nowhere near that of previous economic slowdowns, this is something to monitor.
Bond market: Part 2
Another possible cause for the bond market deterioration is the level of liquidity. There has been a decrease in the financial assets of broker-dealers since the global financial crisis, suggesting reduced capabilities of Wall Street market makers.
Bond market: Part 3
After the financial crisis, the Fed created a facility to help ensure bond market liquidity. Its success can be seen in the increased use of parking collateral of short-term securities used to short the bond market.
What does this all mean? It costs more to borrow….
The interest rate spread between investment-grade corporate debt and the guaranteed return of Treasury bonds is increasing along with the potential for a slowdown. Lenders are increasing the compensation required for holding corporate debt as monetary policy tightens.
… and that includes the money markets
Risk in the money markets increased as an energy crisis in Europe and the United Kingdom became apparent. The money markets are the financing vehicle for business transactions, with the increased cost of doing business adding to inflation pressures.
Middle market businesses are contending with a series of rising costs, from labor to raw materials to financing their operations. Businesses that continue to invest in productivity-enhancing technology will emerge from this period stronger, nimbler and, ultimately, more profitable.