Markets have defied the Federal Reserve in a significant shift over the past two weeks. While Chairman Kevin Warsh previously indicated that financial conditions were tightening enough to support the central bank's goals, investors have moved in the opposite direction. A Bloomberg gauge of US market conditions hit its easiest level since 1996 this Thursday, reversing the tightening trend that defined most of July.
This discrepancy creates a complex situation for policymakers. Since late July, the S&P 500 has climbed nearly 7 percent, while volatility as measured by the VIX has dropped to yearly lows. Furthermore, junk-bond borrowing costs have decreased even though long-term Treasury yields remain high. This movement shows that Wall Street is ignoring the restrictive stance the Fed intends to maintain.
Financial conditions typically tighten when stock prices fall and borrowing costs rise. By making capital cheaper and risk appetite higher, the market is effectively pumping fuel into an economy that the Fed is attempting to cool. Investors are now aggressively buying back into speculative areas like IPOs and high-growth ETFs, which were ignored during the recent period of market caution.
Chairman Warsh noted in late July that the lack of an explicit policy rate change did not mean the Fed was standing still. However, the current behavior of the markets suggests that the intended transmission of Fed policy is facing friction. If the market continues to loosen conditions, the central bank may find itself forced to take more drastic measures to achieve the same result in the real economy.