Just two weeks ago, Federal Reserve Chair Kevin Warsh stated that the market had "largely priced in" the Fed's tightening policies. However, Wall Street has not only fully reversed those expectations but has also gone further.
Bloomberg's U.S. market conditions index fell to its lowest level since 1996 on Thursday, ending a notable reversal that began in late July.
Despite the Fed maintaining interest rates unchanged and long-term borrowing costs remaining elevated, the market has pushed financial conditions to extreme levels not seen in 30 years.
"Financial conditions" is a Wall Street shorthand used to describe the market's risk appetite and the ease of financing. Rising stock markets, calm markets, and lower corporate borrowing costs make financing easier, while falling stock markets and rising borrowing costs make it more difficult.
The index in the chart focuses specifically on these market signals, so it does not mean that mortgages or credit cards have suddenly become cheap. It simply indicates that monetary policy within Wall Street itself is unusually accommodative.
Between Warsh's first Fed meeting on June 17 and the next meeting on July 29, Treasury yields rose, stocks fell, market volatility increased, and corporate borrowing costs rose. The Fed kept its benchmark rate unchanged at 3.5% to 3.75%, but the market grew nervous about this.
Warsh said, "The market has undergone quite a significant change."
Then Wall Street began to accelerate its rally.
Since July 29, the S&P 500 has risen nearly 7%, the VIX volatility index has dropped 6 points to its year-to-date low, and borrowing costs for junk bonds have also declined. Yet, the Fed's benchmark rate remains unchanged.
Long-term yields have risen sharply since Fed Chair Kevin Warsh held his first FOMC meeting on June 17.
Long-term yields have risen sharply since Fed Chair Kevin Warsh held his first Federal Open Market Committee (FOMC) meeting on June 17. — Yahoo Finance AlphaSpace
Market risk appetite has fully emerged. Wall Street's riskiest trades have suddenly returned to the forefront, from Cathie Wood's ARK Innovation ETF (ARKK) to IPOs and other previously neglected speculative areas.
But there is a twist. This situation is not due to a sudden plunge in long-term interest rates. Long-term rates remain high.
Since Warsh's first meeting, the 10-year U.S. Treasury yield (^TNX) has actually risen. The Fed has kept rates unchanged. Yet, the market conditions index shown in the chart has surged to its highest level in 30 years.
Risk-free capital remains expensive. Wall Street has reduced the cost of risk.
This could complicate Warsh's job. If stock markets continue to rise, volatility remains low, and borrowing costs keep falling, Wall Street may continue to fuel the economy that the Fed is still trying to cool down.
There is a deeper issue behind this recent rally. The Fed controls the crucial short-term interest rates, but the market can either reinforce policymakers' intentions or push strongly in the opposite direction. The more Wall Street's stock market rallies, the less help Warsh receives, and the more work the Fed may have to do.
Warsh has made it clear he is aware of this signal. On July 29, he dismissed the notion that the Fed keeping rates unchanged means business as usual.
Warsh said, "Did the Fed explicitly adjust the policy rate today? No. But I think this is just the beginning of the story, not the end."
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