Raising funds on Wall Street has become cheaper and easier despite the Federal Reserve raising interest rates to the highest level in 15 years, suggesting a deep and continuing disconnect between investors and central bank officials.
Measures of financial conditions – the ease with which businesses can access funding – have fallen in recent months, with a closely watched index returning to where it was shortly after the Fed began raising rates in last March.
The divergence has led some investors to warn that the Fed faces a serious communications challenge that could threaten its efforts to keep inflation in check. However, while Fed Chairman Jay Powell has turned down two opportunities in the past week to push back the market’s exuberance, others see his silence as a sign of the central bank’s growing confidence in its victory to control inflation.
“The Fed doesn’t care anymore,” said Greg Whiteley, portfolio manager at DoubleLine Capital. “[They believe] they have the tools to bring inflation down to 2% without market cooperation.
The Goldman Sachs index of U.S. financial conditions hit its lowest level since August after the Fed raised rates last week, while a weekly measure compiled by the Chicago branch of the Fed hit its lowest level since April.
Strong U.S. labor market numbers released on Friday threatened to derail the optimistic trend, with the faster-moving Goldman index advancing marginally higher – indicating tighter conditions – as investors acknowledged the Fed could do more than one more rate hike. Even after the pullback, however, conditions are still near their lowest level since the summer.
Financial conditions provide insight into how the Fed’s monetary policy has trickled down to the real world and is therefore an important part of the central bank’s policy-making calculus. Easing financial conditions and falling Treasury yields can support inflation.
Large-cap US stocks, the biggest contributor to the Goldman index, have rallied significantly in recent months. The S&P 500 has gained 15% from its mid-October low – the same week financial conditions hit their tightest level since March 2020, the start of the Covid-19 pandemic.
Another datum is the spread between junk bond yields and US Treasuries – the premium investors demand for holding riskier debt relative to risk-free government bonds. This figure fell from 5.3 percentage points to less than 4 percentage points over the same period.
After four consecutive interest rate hikes of 0.75 percentage points, the Fed began signaling in November that it was ready to ease the pace of its tightening. Since then, Fed officials have tried to tread a fine line, insisting they plan to keep interest rates high for as long as it takes to bring inflation back to the target of 2%, while slowing the rate at which rates are raised. .
The market did not buy the Fed story. Interest rate futures markets show that investors expect the central bank to cut rates as early as the end of this year, with inflation cooling faster than expected, although the expected magnitude of these reductions have diminished in recent days.
“The difference between market prices and the Fed’s own forecast is a difference in inflation expectations,” said Jay Barry, co-head of US rates strategy at JPMorgan, explaining that the market expects that US inflation falls faster than the central bank.
Annual inflation went from a peak of 9.1% last June to 6.5% in December. Meghan Swiber, US rates strategist at Bank of America, warned that loose conditions could make it harder to curb price increases. “So far, all the cooling has come from goods and commodities,” she said. “The easing of financial conditions makes it more difficult to reduce the more cyclical elements” such as services, she added.
But inflation fell even as financial conditions eased, which may help explain why the Fed has become more optimistic in the face of looser financial conditions.
“I was surprised that Powell was not more resilient to the easing of financial conditions,” said Matt Raskin, head of US rates research at Deutsche Bank. “But that’s because of different expectations about how quickly inflation will come down. We’ve had some positive developments on inflation. Maybe it’s just hard not to sound slightly more brilliant in this context.
The last time the Goldman index fell this far, in August, Powell made an explicit intervention at the annual Jackson Hole summit to warn against easing conditions too quickly. At last week’s press conference, however, he said he was not concerned about “short-term moves”.
On Tuesday, he reiterated that continued evidence of a booming labor market or persistent inflation could force the central bank to raise interest rates more than the market currently expects, but the lack of a harsher warning helped lift stocks and push back expectations of rate hikes. lower.
“My feeling is that the [Federal Open Market Committee] and Mr. Powell are more comfortable having done the heavy lifting,” said Jurrien Timmer, head of global macro strategy at Fidelity. “Six months ago, the Fed would have feared that if it didn’t say the right things, the market would rally and the flames of inflation would continue to fan. Now we are further along in the cycle.