RSM US Financial Conditions Index moving toward neutral

REAL ECONOMY BLOG | August 01, 2023

Authored by RSM US LLP

Having weathered turmoil in the banking sector and the standoff over the debt ceiling, financial conditions in the United States are easing, moving toward levels of risk normally priced into financial assets.

But while signals from the equity market are positive, the bond market continues to price in the possibility of a recession.

Our RSM US Financial Conditions Index looks at levels of risk in three areas: the equity market, the money market and the bond market.

With the money market at normal levels of risk, and with surging equities balancing out the caution displayed in the bond market, our composite financial conditions market is fast approaching neutral.

Even as equities have soared in response to the perceived end of monetary tightening by the Federal Reserve, we would place greater emphasis on the subdued reaction of the bond market as more indicative of what is to come.

In addition, with Japan looking to end its yield curve control policy that targets long-term Japanese yields at zero percent, there is a risk that yields among the major trading nations including the United States may move higher in the coming months.

We expect a pause in the Fed’s monetary policy tightening as prices stabilize and as economic activity continues to regroup. The economy and, specifically, the business community have done a remarkable job in adjusting to labor-market changes brought about by the shock of the pandemic, changes in living preferences and the ongoing technological revolution.

Money market

While the equity market is perhaps best characterized as reactive, the money market can be thought of as the canary in the coal mine, with money-market failure signaling an economic catastrophe.

Risk in the money market has been neutral or slightly lower than normal in the first half of the year, with the exception of the banking turmoil and the debt-ceiling standoff.

This period is unusual, however, with one crisis following another and with the transition of market pricing from Libor to newer sources. And despite the increase in borrowing costs, credit spreads have narrowed for some securities.

That suggests to us that both lenders and borrowers remain selective, which adds to the confidence that if an economic slowdown occurs, it will be absorbed by mitigating factors like the low unemployment rate, higher earnings among low-wage employees, and the safety net provided by excess savings among upper-income households.

Equity market

Although not the best predictor of the business cycle, the equity market has made remarkable gains since the pandemic crash and the more recent inflation shock. That should not be ignored.

The S&P 500 index is nearly 36% higher than its peak in February 2020, just as the pandemic took hold of the economy. That is an average annual return of 9.3% over the past three years and includes the near-full (95%) recovery from the January 2022 inflation shock.

Over the same period, stock prices in the tech sector are up by nearly 46% for an average return of 11.6% per year. The Nasdaq index overall remains down by 10.8% since its November 2021 peak as the demand for everything-tech has cooled and as spending shifts from goods to services.

While not necessarily tied to gross domestic product growth, these stock market gains bolster consumer sentiment that will help support consumer spending.

We would also note that the elevated returns in the equity market during the recovery from the 2008-09 financial crisis and then again during the recovery from the pandemic occurred in periods of near-zero interest rates.

We expect that many households, after years of looking to equities for returns, will once again find returns in the bond market to be attractive and safe. Nevertheless, the recent upsurge in equity prices is a much-needed vote of confidence in the direction of the economy.

Bond market

Volatility in the Treasury market has decreased, but it is still higher than normal. Some degree of increased volatility should be expected now that interest rates have moved off the zero lower bound, widening the range of possible values.

But the up-and-down trading of bond yields in recent months suggests uncertainty among investors as they assess the direction of monetary policy and the economy.

The perceived risk of a recession is captured by the Treasury yield curve, which has become extremely inverted.

The yield on long-term 10-year bonds is lower than risk-free short-term money-market interest rates. And the yield of five-year bonds remains lower than the yield on two-year bonds, with the latter a proxy for expectations of monetary policy. A yield curve inversion has preceded each of the prior recessions in the postwar era.

While some of the blame in this recent period goes to the rapid 525 basis-point increase in the overnight federal funds rate, the bond market is hedging its bet and pressuring long-term interest rates lower.

The takeaway

Although not conclusive because of the speculative nature of the equity market, overall financial conditions are improving.

The performance of the equity market is positive in terms of returns and reduced volatility. While volatility in the bond market is lessening, it remains elevated as Treasury yields continue to price in the risk of a recession. Whether that is a false positive remains to be seen.

The implication for borrowers and lenders in the business community is to continue to exercise selectivity and caution.