Bond Market Could Be Doing the Fed's Tightening for It, and That Could Help Stocks

Financial conditions in the United States are tightening without any help from the Federal Reserve, and a Morgan Stanley strategist thinks that could be good news for equity investors. The argument is that a stronger dollar, higher bond market yields and elevated gasoline prices are already doing the work of a rate increase, which may leave the central bank under Kevin Warsh with little reason to lift rates further.

Financial conditions are a broad measure of how easy or hard it is to borrow, spend and invest. A firmer dollar makes imports cheaper and squeezes exporters. Rising yields push up mortgage rates, corporate borrowing costs and the price of new debt across the economy. Expensive fuel takes money out of household budgets. Taken together, the strategist's point is that markets have applied a meaningful squeeze on their own, without waiting for policymakers to act.

For stocks, the picture is more nuanced than it first appears. Tighter conditions are rarely welcome for equities in the short run. But if the bond market is already doing the job, the Fed may be able to hold steady instead of tightening again. Investors have often reacted more favorably to a central bank that has finished raising rates than to one that is still in motion, so a market-driven tightening could leave room for shares to recover.

The view is not without risk. If the squeeze runs too deep, it could slow growth more than policymakers want, and a sudden drop in yields would bring its own complications. Investors will be watching whether the dollar and gasoline prices ease from here, and whether Fed communications suggest the current stance is enough.