(Bloomberg) — A rebound in risk assets could prove to be a problem for a Federal Reserve trying to curb excesses across markets.
Stocks have bounced sharply since mid-May’s lows and credit spreads have tightened back to levels seen ahead of the March liftoff of interest-rate hikes while the Bloomberg Dollar Spot Index has cooled from two-year highs reached earlier this month. Taken together, a Bloomberg measure of US financial conditions — a cross-asset measure of market health — has returned to levels seen before March’s hike.
That potentially poses a problem for policy makers. Fed chief Jerome Powell has repeatedly said that financial conditions will compress as the central bank removes monetary support in a bid to combat the hottest inflation readings in four decades. Should price pressures build and growth remain robust while markets continue to rally, the Fed may need to tighten the reins even more, according to 22V Research founder Dennis DeBusschere.
“The mechanism through which the Fed is impacting the real economy is through the financial conditions channel,” DeBusschere said on Bloomberg Television. “If the data doesn’t slow, financial conditions will need to tighten more.”
The easing in conditions follows a week in which practically everything from speculative to blue-chip stocks rose as traders scaled back rate-hike expectations, fueling a drop in Treasury yields. The S&P 500 snapped its longest weekly losing streak in a decade en route to its biggest rally since 2020, while a basket of unprofitable tech shares ended a seven-week decline.
To strategists at Morgan Stanley, last week’s jump in stocks is a little more than a hiccup amid a broader decline, especially with a Fed eager to cool demand.
“The more equity prices rise, the more hawkish the Fed will be,” Morgan Stanley’s Michael Wilson wrote in a report Tuesday. “Investors may be underestimating the Fed’s willingness to shock markets if necessary to achieve its inflation goals.”
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