Federal Reserve Chair Kevin Warsh is happy to let financial markets do some of the central bank's work, he should be pleased with the recent selloff in stocks and bonds. But the recent tightening in financial conditions is far from enough to let him off the hook.

The new Fed boss has repeatedly made clear that overall access to finance shows little sign of being restricted by the central bank, despite an economy that has proven resilient and continues to generate uncomfortably fast price growth.

In his keynote speech at the Jackson Hole conference in August — a speech that clearly flagged the Fed's first interest rate rise in three years last month — Warsh detailed aspects of lending, credit and market behaviour that suggested prevailing Fed policy was simply not tight enough.

"On balance, I would be hard-pressed to describe broad financial conditions as restrictive," he said then.

The question for investors is whether that's still the case, and whether higher bond yields, wider credit spreads and stock-market volatility since August have tightened financial conditions enough to keep the Fed at bay. The answer seems to be "not yet".

But a cat-and-mouse game between markets and Fed expectations may now play out over what could be a bumpy year-end.

The Chicago Fed's National Financial Conditions Index (NFCI) is one place to see the overall impact of recent market turbulence. By the end of last week, it had risen to the tightest level since April, while the Goldman Sachs equivalent had hit its tightest since March.

That shows the greater difficulty in raising debt or equity since the Fed hiked rates and catapulted expectations for further rate rises higher over the coming year.

Underlying price shifts since Warsh's Jackson Hole appearance show where that's been felt most.

Even though it is well off its recent 24-year peak, the benchmark 10-year Treasury yield is still up almost 50 basis points over the intervening two months. Thirty-year fixed mortgage rates are up 70 bps and US junk bond risk spreads (.MERH0A0) have widened by almost 100 bps.

Reflecting the mortgage squeeze, housebuilding sentiment as measured by the National Association of Home Builders fell this month to its lowest level in 14-1/2 years.

Crude oil futures are up more than 20% over the past two months and the dollar (.DXY) is up almost 3%.

Buoyant stock indexes, riding the AI boom, had offset edgier credit and debt markets for the past year or more — until last week. But that's no longer happening, with the S&P 500 (.SPX) and tech-heavy Nasdaq (.IXIC) basically unchanged since Jackson Hole.

Just as significantly for financial conditions, equity volatility embodied by the VIX "fear index" (.VIX) has started to stir too, signalling danger ahead and increased risk for initial public offerings and equity financing. It hit its highest level in four months on Friday.

The bond market equivalent (.MOVE), often important for finance via securities repurchase, or repo, markets, has also surged back to March levels since August.

Higher equity values intuitively loosen financial conditions via wealth effects, and vice versa, but the way the Chicago Fed's NFCI is compiled shows where the real pressure points lie.

The index is broken down into three categories: risk, credit and leverage. The VIX is a component of the risk subsection, higher-risk credit is often correlated with equities, and leverage readings hinge on debt-to-equity ratios that are highly sensitive to equity prices.

The threat of a blowup at the epicentre of the highly leveraged AI buildout, as seen with CoreWeave (CRWV.O) last week, could ripple through wider financing conditions and indexes that capture them quite quickly.

That helps explain why the bond market, while absorbing two worrying inflation reports last week, rallied hard on signs that the AI rally underpinning stock benchmarks may be about to roll over. However, the tipping point seems some way off. Even though the Chicago Fed index is at its tightest since April, it remains well below its 20-year average and has remained on the loose side for the best part of three years.

But there are other readings on financial conditions that suggest the recent tightening may be more extreme. Morgan Stanley's equity strategist Mike Wilson and team said on Monday that their financial conditions index (FCI), a compilation of rates, the dollar and energy prices, was at its tightest since 2022. They also noted that economically sensitive stocks have lost nearly 10% since August.

"Some acknowledgement of this tightening by Warsh would be well received by rate-sensitive areas that have already de-rated notably," they said.

As for Warsh, he's now in a blackout period along with his Fed colleagues until next week's policy meeting, and there appears to be a consensus that the next rate rise will not come until December.

But some saw his comments at the International Monetary Fund meeting last week in Bangkok as indicating that he still didn't think the Fed had yet done all it needed to do to rein in inflation.

In describing the Fed's September hike, Warsh said, "We removed a dose of accommodation" — clearly not all of the accommodation, suggesting he still thinks conditions are too loose.

If the Fed does skip a rate rise next week, just six days before the midterm elections, it would probably take a significant further jolt in financial conditions over the following six weeks for policymakers to stay their hand at year-end.