Tight(er) financial conditions will end the bull market

Another Inconvenient Truth Today’s Consensus Refuses to Acknowledge

“As the Federal Reserve nears the end of a historic cycle of interest rate increases,” wrote Sarah Hansen (“What Does It Mean That Financial Conditions Are Tightening?” Morningstar, 20 October 2023), “market watchers are anxiously eyeing evidence of how much those hikes have affected – or will continue to affect – markets and the economy.”

These observers included Jerome Powell. “Financial conditions have tightened significantly in recent months,” the Fed’s chairman asserted in a speech at the Economic Club of New York earlier that month. The jump of long-term bond yields, he added, was “an important driving factor in this tightening.”

“Measures of financial tightness (or looseness),” says Hansen, “provide a snapshot of the health of the economy and its prospects for growth in the months and years ahead. These are important tools for policymakers and investors alike.” The looser the conditions, supposes the conventional wisdom, the healthier the economy and the rosier its prospects.

What does financial tightness and looseness mean? Earlier in 2023, the Fed’s analysts wrote: “’financial conditions’ is a somewhat vague economic concept but typically (it) refers to a constellation of asset prices and interest rates that are influenced by a variety of factors – including monetary policy – and have the potential to affect the real economy. Because of the ambiguous definition, measuring financial conditions is challenging” (see “A New Index to Measure U.S. Financial Conditions,” Fed Notes, 30 June 2023).

In their note, the Fed’s analysts unveiled a new financial conditions index (FCI) which “aggregates changes in seven financial variables – the federal funds rate, the 10-year Treasury yield, the 30-year fixed mortgage rate, the triple-B corporate bond yield, the Dow Jones total stock market index, the Zillow house price index, and the nominal broad dollar index – using weights implied by the FRB/US model and other models in use at the Federal Reserve Board. These models relate households’ spending and businesses’ investment decisions to changes in short- and long-term interest rates, house and equity prices, and the exchange value of the dollar, among other factors.”

The Fed’s data enable it to construct FCI-G only since 1988. For reasons that’ll shortly become clear, that makes me suspicious.

Since the end of 2021, FCI-G indicates, financial conditions have tightened, and this “has been primarily driven by lower equity prices” – that’s odd, to say the least, but it’s what they say – as well as “higher interest rates … and the stronger dollar. Moreover, since the second half of (2022), the largest headwinds to future growth stem from the changes in short- and long-term interest rates and the dollar …”

Existing FCIs, such as the Federal Reserve Bank of Chicago’s and Bloomberg’s, typically measure whether financial conditions at one past point in time are tight or loose relative to those at another; FCI-G, in contrast, assesses the extent to which financial conditions “pose headwinds or tailwinds to future economic activity.”

The Chicago Fed’s NFCI

The National Financial Conditions Index (NFCI) of the Federal Reserve’s Chicago branch has since 1971 provided “a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets, and the traditional and ‘shadow’ banking systems. Because U.S. economic and financial conditions tend to be highly correlated, we also present an alternative index, the adjusted NFCI (ANFCI). This index isolates a component of financial conditions uncorrelated with economic conditions to provide an update on financial conditions relative to current economic conditions.”

“The NFCI and ANFCI are each constructed to have an average value of zero and a standard deviation of one over a sample period extending back to 1971. Positive values of the NFCI have been historically associated with tighter-than-average financial conditions, while negative values have been historically associated with looser-than-average financial conditions. Similarly, positive values of the ANFCI have been historically associated with financial conditions that are tighter than what would be typically suggested by prevailing macroeconomic conditions, while negative values have been historically associated with the opposite.”

Figure 1 plots the NFCI’s standard deviation (the ANFCI is closely correlated to it; therefore, I’ve omitted it) since January 1971. Four results are most noteworthy. Firstly, apart from a few relatively brief intervals (September 1972-January 1973, May 1975-March 1978, April 1983-Matrch 1984 and January 1985-April 1987) before September 1987 it was positive and thus financial conditions were tight. Second, before September 1987 financial conditions were often very restrictive – that is, NFCI exceeded 2.0.

Figure 1: Federal Reserve Board of Chicago, Financial Conditions Index, Standard Deviation, Weekly, January 1971-March 2025

During 70.1% of the months since January 1971, NFCI has been below zero – that is, financial conditions have been loose. And during the 29.9% of the months when NFCI has been above zero, financial conditions have been very tight – that is, NCFI has exceeded 1 – 44% of the time.

Thirdly, with just two exceptions since March 1991 (August 2007-October 2009 and March-May 2020, i.e., the Global Financial Crisis and COVID-19 Crisis) financial conditions have been loose. Finally, never mind Jay Powell: over the past couple of years conditions have loosened further: from -0.10 in March 2023 to -0.60 in March 2025.

The Federal Reserve’s St Louis branch (“Are financial conditions tight or loose?”The FRED® Blog, 24 December 2024) agrees: “since the pandemic, credit spreads (the margin between the yields of corporate and Treasury bonds) have narrowed … Further, spreads are currently about half a standard deviation below the historical mean across all investment-grade categories (of bonds). This suggests that financial conditions are loose.”

Lax Conditions Today Beget Turmoil Tomorrow

“Loose financial conditions,” the International Monetary Fund recently noted (“How High Economic Uncertainty May Threaten Global Financial Stability,” 24 October 2024), “can exacerbate risks of financial market turmoil.”

In “Loose Financial Conditions, Rising Leverage, and Risks to Macro-Financial Stability” (6 April 2021) it elaborated: “leverage in the nonfinancial private sector reached historical highs for many economies in the run-up to the COVID-19 crisis, reflecting easy financial conditions in the aftermath of the global financial crisis. Leverage has since increased even further as policymakers have stepped in to prevent disruption to the flow of credit to households and firms.” 

“While loose financial conditions are still needed to support a nascent recovery,” the IMF concluded, “they could exacerbate the buildup of leverage and increase downside risk to future economic activity.” Policymakers thus face a trade-off: the more they boost growth in the short term by easing financial conditions, the more they accumulate risks to long-term growth – including economic and financial crises.

This trade-off can’t exist forever: the longer policymakers artificially stimulate economic growth, the greater is the risk of financial crisis. At some point, therefore, financial conditions must tighten and remain tight. Today’s over-imbibing doesn't merely precede - it causes - tomorrow’s hangover.

Financial Conditions and Equities’ Valuations

Why don’t bullish investors want to know the relationship between financial conditions on the one hand and stocks’ valuations on the other? Perhaps because, as Figure 2 demonstrates, it’s negative: the higher is the NFCI (that is, the tighter are financial conditions) the lower is the Cyclically Adjusted Price-to-Earnings ratio (CAPE, which measures the long-term valuation of the stocks which comprise the S&P 500 Index).

Figure 2: Impact of NFCI (X-Axis) upon the S&P 500’s CAPE (Y-Axis), Monthly, January 1971-March 2025

When financial conditions are loose (that is, NFCI is less than zero) CAPE has varied considerably: from less than 10 to as high as 45, and has averaged 24.8. When NFCI is greater than zero, however, CAPE varies over a much more restricted and lower range, from 7 to 20, and has averaged 14.

Correlation, of course, isn’t a sufficient condition of cause. Equally clearly, it’s a necessary condition. Decades ago, comparatively tight financial conditions were associated with relatively low equity valuations. What, then, would happen if financial conditions subsequently cease to be very loose and become moderately tight (such that, for example, NFCI averaged 1.0)?

If past is prologue, CAPEs would be closer to 14 than the current 38 – that is, a collapse of the S&P 500 by more than 50% (see also Why Australian equities will again outperform, 25 August 2024, Does Dow 40,000 Vindicate Dow 36,000? 19 May 2024 and Why the S&P 500’s five-year prospects are poor, 26 December 2023).

But during bull markets nobody wants to acknowledge such inconvenient truths.

Inconvenient Truths and the “Rumsfeld Matrix”

In response to a question at a press briefing on 12 February 2002 regarding the lack of evidence linking Iraq’s government to the supply of weapons of mass destruction (WMDs) to terrorists, the U.S. Secretary of Defence, Donald Rumsfeld, (in)famously stated:

“… there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say, we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know.”

This comment earned him the 2003 Foot in Mouth Award from the British Plain English Campaign (“Rum remark wins Rumsfeld an award,” BBC News, 2 December 2003). He apparently took no notice, and titled his autobiography Known and Unknown: A Memoir (Sentinel, 2011).

Empirically, no Iraqi WMDs were ever located; logically, Rumsfeld’s statement provides the basis of a simple yet sophisticated categorisation of knowledge. As the Australian economist and blogger, John Quiggin – hardly a supporter of American neoconservatives – wrote (“In Defence of Rumsfeld,” 10 February 2004): “although the language may be tortured, his basic point is both valid and important.”

Several books about risk assessment and management have elaborated it. Mikael Krogerus, et al., for example (The Decision Book: Fifty Models for Strategic Thinking (W.W. Norton & Company, 2012), have constructed a “Rumsfeld Matrix” (Table 1).

Table 1: the “Rumsfeld Matrix”

In To lift your returns, swap these risks (8 November 2024) I distinguished risk from uncertainty. Risk refers to known potential outcomes and quantitative estimates of their likelihoods; uncertainty entails outcomes which are unknown or unknowable (perhaps because they haven’t been experienced or can’t be anticipated) and whose probabilities therefore can’t be estimated.

Consider as a simple example a single roll of a fair die. Logically, six results are possible: 1, 2, 3, 4, 5 or 6. These are the only possibilities; hence there’s no uncertainty. What will be the result of a single roll? We don’t know for sure, hence there’s risk; but we certainly do know that each result is equally probable; hence the risk that each possible result occurs is 1 ÷ 6 ≈ 16.6%.

On that basis, two of the table’s four cells (in the column headed “Aware”) are relatively easy to grasp:

1. “Known knowns” are things which you know and are aware that you know. There’s just one possible outcome; hence its probability is 100%: the sun will rise over the horizon tomorrow morning, 1 + 1 =2, etc. You will pay taxes, then you’ll die. There’s neither risk nor uncertainty.
2. “Known unknowns” are recognised but poorly understood compared to “known knowns.” You don’t know, and you’re aware that you don’t know. Will the toss of a fair coin produce heads or tails? There’s no uncertainty, but there’s risk. Will geopolitical events affect X Ltd? Which one(s)? One year hence, what will be the rate of consumer price inflation? In these instances, there’s uncertainty (possibilities which we haven’t considered) as well as risk (multiple possible outcomes).

Table 1’s other two cells (column headed “Unaware”) are more subtle and difficult to grasp because they reflect at least as much uncertainty as risk.

“Unknown unknowns” are things we don’t know – but nobody’s aware of it. In other words, we don’t know that we don’t know. These are things which we don’t anticipate because we’ve never experienced them and have no reason to do so. Should unknown unknowns become significant known unknowns – that is, we realise that we don’t know – we could realise that they pose great risks.

As an example, before 11 September 2001 nobody expected – because nobody imagined – a terrorist attack by means of aeroplanes which destroyed the World Trade Centre.

“Unknown knowns” are the most difficult to grasp; perhaps that’s why Rumsfeld omitted to mention them. They may describe things which you know – or reasonably should know – but you’re unaware of it. They may also describe situations where you’re a patsy: others know but you don’t. Slavoj Žižek, a "psychoanalytic philosopher" (should I know what that is?), says that they describe situations in which, intentionally or subconsciously, one refuses to acknowledge that one knows. 

He provides an example: “if Rumsfeld thinks that the main dangers in the confrontation with Iraq were the ‘unknown unknowns,’ that is, the threats from Saddam whose nature we cannot even suspect, then the Abu Ghraib (prison) scandal shows that the main dangers lie in the ‘unknown knowns’ – the disavowed beliefs, suppositions and obscene practices we pretend not to know about, even though they form the background of our public values” (“What Rumsfeld Doesn’t Know That He Knows about Abu Graib,” In These Times, 21 May 2004).

“Unknown knowns” are inconvenient truths – those which we could and should know, but don’t want to acknowledge and thus suppress. A recent article Never mind DeepSeek: here’s why the AI mania won’t last, 3 February 2024) considered one inconvenient truth; this article has described and analysed another.

Implications and Conclusion

Investing, like life in general, doesn’t just entail – it necessitates – trade-offs (see, for example, To lift your returns, swap these risks, 8 November 2024). Loose financial conditions of the past 30 or more years have boosted stocks but increased the risk – and the occurrence – of major market turmoil. Tighter conditions mitigate this risk – at the cost of crimping or crushing stocks’ valuations and returns. 

The phrase “climbing the wall of worry” refers to the attitudes and behaviour of investors during bull markets: their concerns and prominent experts’ negative and sometimes dire forecasts don’t affect their strong appetite for stocks. During ebullient periods, markets respond little or not at all to corporate, economic, financial, geopolitical and other news which might otherwise spark selloffs, corrections, panics and bear markets, etc.; instead, they push ever higher.

A “wall of worry” sometimes comprises a single risk, but it usually includes numerous ones. Risks, in terms of Rumsfeld’s Matrix, are “known unknowns.” The wall of worry thus excludes “unknown knowns” – that is, inconvenient truths like those I’ve considered.

These inconvenient truths include 

• America’s inability since the GFC to grow its GDP without a mammoth budget deficit; the dependence of large deficits upon lax monetary policy; and its consequent inability to shrink its unsustainable deficit without greatly increasing the risk of recession (see The consensus is wrong: America’s economy is chronically ill, 13 January 2025);
• the inability of so-called “tech revolutions” permanently to increase productivity’s rate of growth, and thus to justify tech stocks’ lofty valuations (see Never mind DeepSeek: here’s why the AI mania won’t last, 3 February 2025);
• as this article has demonstrated, the impact of monetary tightening upon stocks’ valuations.

Markets’ ability to climb a wall of worry reflects investors’ ability to ignore, discount or deny inconvenient truths; it thereby indicates their confidence that policymakers will either delay hard decisions (“kick the can down the road”) or that problems will somehow abate or disappear. 

Today, “investors” – “speculators” is more apt – subconsciously but nonetheless fervently believe three falsehoods above all else.

Firstly, they believe that America’s GDP (and, by implication, that of other major economies) can grow indefinitely despite these governments’ huge budget deficits – and resultant very high and rapidly rising national debt. Secondly, and as they did during the Dot Com bubble, they believe that revolutionary advances of technology accelerate productivity’s rate of growth. Hence they incorrectly infer – as Alan Greenspan did 30 years ago – that these advances place on sound and sustainable ground tech stocks’ past, present and future strong returns.

Finally, most generally and perhaps most fanatically, today’s speculators believe that central banks have, through their loose monetary policies since the Crash of 1987, backstopped stocks’ abnormally strong (by long-term historical standards) returns.

This belief has long been mostly justified; its consequences, however, have been increasingly dangerous. How long can the past generation’s lax monetary policy persist? I don’t know, but suspect that it will cease when central banks finally acknowledge that its costs increasingly exceed its benefits.

What became known as “the Greenspan put” was the repeated and thus dependable response of central banks to actual financial crises and possible recessions – loose monetary policy – that Alan Greenspan commenced during the Crash of 1987. In the short-term, it successfully tamped crises and averted or moderated recessions.

In the long term, however, it and its successors have encouraged the speculation which has created the bigger imbalances which foment the more severe crises which allegedly necessitate ever more aggressive monetary intervention (see, for example, Tim Duy, “Powell’s Fed Isn’t About to End the ‘Greenspan Put,’” Bloomberg News, 13 February 2018).

In November 2020, Bloomberg reckoned that the “Powell put” is more powerful than both the “Greenspan put” and the “Bernanke put” (see John Authers, “The Fed’s Stocks Policy Is Exuberantly Asymmetric,” 4 August 2020). Time magazine noted both the scale of Powell’s monetary intervention in 2020 and its principal side-effect – not merely the Fed’s tolerance of asset bubbles, but the economy’s rising dependence upon them (see Christopher Leonard (see “How Jay Powell's Coronavirus Response Is Changing the Fed Forever,” 22 June 2020).

What happens if “unknown knowns” become “known unknowns? That is, if things which investors don’t want to acknowledge finally and perhaps suddenly become risks which they must consider? When past loose policy creates the imbalances, stubbornly high consumer price inflation, etc., which only tomorrow’s tight(er) financial conditions can quell? What, in short, happens when fiscal and monetary policymakers can no longer ignore and delay hard decisions?

Most fundamentally, what will occur when investors again recognise that governments including central banks cannot suspend, never mind repeal, laws of economics? That their increasingly crazed attempts to do so merely create the artificial booms which trigger genuine – and ever more severe –busts?

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