Financial markets in the United States are pricing in a longer duration of the war in the Middle East.
Our RSM US Financial Conditions Index, which has been decelerating since early February, has turned negative, implying a modest drag on growth.
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In addition, the short end of the Treasury curve illustrates pressure building in American financial markets that will push rates higher as the consequences of the energy shock come into view.
What is behind this move?
- Equity market: The S&P 500 has fallen by 8% since its January peak.
- Bond market: The bond market has been selling off as well. The yield on the benchmark 10-year Treasury bonds has increased by 50 basis points since the attack on Iran on Feb. 28, rising from just below 4.0% to 4.5%.
- Money market: Finally, money market rates are increasing as higher risk is priced into commercial loans, causing a remarkable steepening at the front end of the bond market yield curve. This steepening encompasses the widespread cost of inflation and its impact on U.S. and global economic growth.
Increased cost of doing business
The prospect of an enduring energy shock has affected the short end of the Treasury yield curve, which is attuned to expectations of the monetary policy response to inflation.
For instance, in a deflationary climate, the prospect of a recession and lower rates of employment would weigh on money market rates in anticipation of the Federal Reserve reducing its overnight policy rate.
But in the current environment, the opposite occurs, with the money market anticipating the impact of an energy shock on prices.
Given the increase in inflation expectations, short-term T-bill rates have moved higher since the attack on Iran. The 12-month T-bill interest rate has increased by 30 basis points.
Further out the curve, the 2-year Treasury note has twice tested 4.0%, more than 50 basis points higher than before the attack on Iran.
The 2-year is regarded as the present value of future Fed policy rates, with its current yield signaling expectations of the Fed hiking its policy rate two times.
While we do not expect a rate hike, nor would we advocate one, it reflects the stress building in the financial system as well as the impact of the war.
Finally, the jump in short-term rates implies higher operating costs for businesses that are meeting their weekly payroll or borrowing for spring activities.
And in the longer term, higher short-end rates influence the cost of corporate borrowing. As 5-year Treasury yields rise, the cost of borrowing in the corporate bond market will increase as well.
The takeaway
The U.S. economy is benefiting from investments in productivity made during the pandemic when interest rates were abnormally low and the labor market was extremely tight.
Having weathered the inflation of the pandemic and the Ukraine war, the financial markets are once again pricing in the inherent risk of inflation in a global energy shock.
Investors in U.S. financial securities are now requiring additional compensation for the risk of inflation and the diminished real return on their investment.
Understanding the RSM US Financial Conditions Index
Our RSM US Financial Conditions Index aggregates the risk priced into three financial markets: the money market, bond market and equity market.
An index value of zero represents normal levels of risk.
Positive values of the index suggest an accommodative climate for investing, which is conducive to economic growth.
Negative values imply increased financial risk and a diminished propensity for borrowing and lending, which suppresses investment and lowers earnings and economic activity.