Retail investors continue to eagerly buy every dip or decline in stocks in hopes that stock prices will soon make new all-time highs. While they’re throwing money at stocks, they can’t see the warning signs that financial conditions are tightening. When financial conditions become too tight, risk assets tend to crash.
Investors are willfully blind to these warning signs as they believe stocks can and will only go up. Yet, the U.S. dollar is slowly rising, and long-term Treasury yields are falling. These two indicate easy financial conditions are behind us and investors should heed their warning.
With the Federal Reserve expected to announce an increase in its balance sheet taper at its Dec. 14–15 Federal Open Market Committee meeting, financial conditions are going to tighten even quicker. What retail investors fail to see is how a rising dollar and falling Treasury yields are screaming that current and future financial conditions are going to tighten.
The reason expectations for tighter financial conditions are rising has to do with how quantitative easing causes the money supply to grow. Quantitative easing is a large contributor to the expansion of the money supply, so as the Fed tapers and eventually ends its large-scale asset purchase program, the growth rate of the money supply should fall below trend.
With asset prices at extremely high levels, the money supply needs to continue expanding to support them. Without a sufficient number of new dollars being created to support asset prices and the Fed expected to end its program early next year, the value of existing dollars should rise as dollars become more valuable. Many investors fail to understand how the value of the dollar indicates whether current financial conditions are easing or tightening.
As the global reserve currency, the value of the dollar determines if current financial conditions are easing or tightening. When the dollar is falling in value, current financial conditions are easing and when the dollar is rising in value, current financial conditions are tightening. How low or high the dollar goes determines how loose or tight financial conditions are.
While the value of the dollar denotes current financial conditions, the value of Treasury bonds denotes future financial expectations. After all, a U.S. Treasury security is simply a form of future dollars. An investor buys a Treasury bond with the expectation of receiving those dollars back, along with a monthly dividend, at a predetermined point in the future.
When long-term Treasury yields are rising, it means future financial conditions are likely to ease and when long-term Treasury yields are falling, it means future financial conditions are likely to tighten. While this relationship appears backward to most, it’s correct.
When long-term Treasury yields are high and rising, they’re doing so to soak up excess money in the financial system, which is why rising long-term Treasury yields suggest future financial conditions are likely to remain loose. Low and falling long-term Treasury yields indicate there’s an expected shortage of money in the financial system and rates need to fall to spur the creation of new money through lending.
When the dollar is falling and Treasury yields are rising, it means current financial conditions are easing and future expectations are likely to ease. Financial conditions can ease for a variety of reasons, which include fiscal stimulus, easy monetary policy, and an increase in commercial bank lending.
In the months following the pandemic, the dollar fell as the Federal government borrowed money from domestic and foreign sources, then transferred it to consumers and businesses who eagerly spent dollars into the real economy. Fiscal stimulus eased current financial conditions that would have otherwise been tight as the economy was forcibly shut down.
The Fed further eased financial conditions by engaging in large-scale asset purchases or quantitative easing that led to the suppression of interest rates, which helped expand commercial bank lending. When commercial banks lend, new money is created.
As fiscal stimulus hit consumer bank accounts and commercial lending spiked, Treasury yields began to rise. Long-term Treasury yields rose as expectations rose that future financial conditions would further ease, as investors believed the Fed’s easy money policies would fuel a rapid expansion of the economy.
Today, the dollar is rising and Treasury yields are falling, which indicates current financial conditions are tightening and expectations are rising that future financial conditions will also be tight. Investors should be forewarned, as when the dollar is rising and Treasury yields are falling, it usually means risk assets are about to crash.
Leading into the Great Financial Crisis, the dollar rose as long-term Treasury yields collapsed. The dollar rose as yields fell heading into the December 2018 correction and the March 2020 crash. While this time may be different, investors should be aware that financial conditions are tightening right before their eyes.
