Why financial conditions indices matter - in any marketContributor Kelsey Berro
When market conditions are easy, nobody gives financial conditions indices (FCIs) the time of day. With headline risks bringing FCIs sharply back into focus, let’s start by putting this year’s experience into perspective.
In the first few months of 2016, US equity prices fell over 10%, 10-year Treasury yields rallied 60bps and 10-year inflation break-evens declined to post-crisis lows. Last year, the market narrative was fear of a recession in the US, a hard landing in China, and a global growth meltdown. At that time, market strategists were quoting measures of financial stress and their paralysing effect on markets and central banks.
In the first quarter of 2017, market strategists didn’t seem interested in FCIs. But we should be monitoring FCIs all the time—not just in challenging markets. Here’s why:
Tighter financial conditions have a lagged negative impact on growth—and vice versa.
A combination of factors influence financial conditions, including equity prices, credit spreads, the dollar, and the level of interest rates. Higher equity prices increase household wealth and promote spending; tighter credit spreads and lower interest rates reduce borrowing costs for households and corporations thus encouraging borrowing and investment; and a weaker dollar improves the price competitiveness of US businesses that export.
Since the start of this year through the end of April, the S&P 500 has risen over 6%, the trade weighted US dollar has declined by over 2.5%, BBB credit spreads were mostly unchanged and the 10-year Treasury yield is 16bps lower. All of these factors point to easier FCIs. And the best news is that we have yet to get the full benefit of easy financial conditions over the past four months on the US economy. This impulse is likely to boost growth and consumption spending in the coming quarters.
Tight financial conditions in 2015/2016 kept the Fed from hiking rates the four times it promised last year.
So far this year, FCIs have actually acted as a tailwind propelling the Fed forward and upward. Consider the fact that the ultimate reason that a central bank raises interest rates is to slowdown an economy through the “financial conditions channel” when an economy no longer needs support, and is accelerating at a pace that could lead to an overshoot in growth and inflation in the future. Think back to the Fed’s last hiking cycle from 2004 to 2006 where equity prices rose over 10%, financial conditions eased and imbalances were created, specifically in the housing market, despite the Fed increasing rates 17 times. At the time, the pace of rate hikes was considered “measured” by investors compared to prior cycles, but ultimately was not aggressive enough to shake out excessive leverage and risk-taking in the US financial system, thus leading to a bubble and subsequent crash in 2007-2009. As professional academics and students of history, the economists at the Federal Reserve have recognised this error and are unlikely to want a repeat performance.
Things can change quickly and it’s best not to be caught on the hop when FCIs turn.
The Fed knows this too. Last year, the Fed needed to be extremely cautious and slow moving as financial conditions were tightening sharply in 2015 and early 2016. Today, this is not the case. One popular measure of financial conditions (shown below, created by Goldman Sachs) is now easier than it was when the Fed first starting hiking in 2015. This is why the first two years of this so-called tightening cycle should not necessarily be reflective of the future.
The Fed has promised two more rate hikes this year and three more next year, while the market is pricing in less than 1.5 hikes in 2017 and less than 1.5 hikes in 2018. Given the state of FCIs over the first few months of this year, markets should be pricing in more action from the Fed. The risk, of course, is that financial conditions tighten suddenly and sharply. Risk markets are vulnerable to shocks which could be triggered by a number of factors including those currently emanating from Washington, D.C.
As the Fed approaches its mandate objectives, the path of the Federal Funds rate will not be derailed by one bad payrolls or inflation report. Instead, it will be shaped by the magnitude and the pace at which financial conditions tighten or loosen.
Financial conditions have loosened despite tighter monetary policy
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