Financial conditions and an exuberant equity market

Despite continuing calls for the Federal Reserve to slash rates, the American economy continues to show resilience: Growth is near its potential, unemployment is still low at 4.3%, inflation is rising but under control, and financial conditions remain conducive for investment.

In fact, the RSM US Financial Conditions Index continues to signal a moderate level of accommodation in the financial markets.

The money and bond markets seem to have accepted the new status quo of a slowing labor market and increased spending, while the equity market appears to be ignoring the potential impact of tariffs on corporate earnings.

The Fed is tasked not only with maintaining reasonable levels of inflation and employment, but also with facilitating the normal operation of the financial markets. This is accomplished by monitoring financial conditions.

If financial conditions become too restrictive (with rising risk levels inhibiting investment), the Fed is expected to lower the cost of credit by reducing its overnight policy rate.

If financial conditions become too lax (with not enough risk factored into investment), the Fed is expected to increase the cost of credit to cool excessive spending or speculative investment.

The Fed’s most recent assessment of the economy and financial markets in September suggested a gradual and modest resetting of its policy rate to address the downside risk to employment in an economy growing just below its potential.

All this remains subject to the deployment of tariffs and their impact on price stability, and the potential impact of a geopolitical shock on the more speculative equity market.

Equity market exuberance

The Fed has demonstrated its ability to maintain liquidity in the money market should a crisis occur, while the bond market has the capacity to adjust to expectations for economic growth and inflation.

But a potential bubble in the equity market is more difficult to address directly, particularly at a time when distortions in the labor market require the immediate attention of policymakers.

After past equity crashes, the Fed has responded by injecting liquidity through measures such as opening up lines of credit and dropping interest rates.   

In this recent episode and on the positive side, the equity market’s enthusiasm for the potential of artificial intelligence to boost corporate profits seems to have outweighed concerns about declining U.S. productive capacity and the imposition of tariffs. We saw this in the short-lived market correction in April.

After reacting precipitously to the initial tariff shock, the tech-heavy S&P 500 and Nasdaq indexes are now setting records as S&P 500 volatility falls below its long-term average.

Even the more traditional Dow Jones Industrial Average and the Russell 2000 small-cap index have more than recovered their losses.

Which leads to a question: Is this a bubble in the making?

Measuring a bubble

Our composite equity market performance measure, based on S&P 500 returns and their volatility, in mid-September moved one standard deviation above the risk level that would normally be expected based on past business cycles.

While not yet qualifying as a bubble at one standard deviation, the persistence of high returns and low volatility suggests a level of speculative behavior that could easily go south, as we’ve seen several times over the past 15 years.

Our equity performance index has tended to trade within zero to one standard deviation but drops precipitously below zero in reaction to adverse geopolitical events.

We attribute sudden moves down and then up again to the speculative nature of investment in the stock market.

This is in contrast with the bond market, which is attuned to the direction of the economy and inflation, and the money market, which reacts to the liquidity of short-term lending.

The Fed’s recent decision to reduce the effective federal funds rate by 25 basis points to 4.08% would be only the first step should a geopolitical crisis occur. Predicting those events is nearly impossible.