A look at global financial conditions

by Sean Tweedie | May 31, 2022

Global Financial conditions play an important role in monetary policy decisions taken by Central Banks. Essentially financial conditions can be defined as how easily money and credit flow through the economy via financial markets by examining indicators. Most Financial Conditions Indices (FCIs) include bond yields, credit spreads, equity prices and the exchange rate as inputs. Central Banks see financial conditions as a key driver of the real economy. Higher bond yields, wider credit spreads, lower equity prices, and a strong currency all lead to tighter financial conditions and a weaker economy, and vice versa.

One such index which is popular amongst market participants is the Goldman’s US FCI. It is calibrated so that 100 bps in tightening corresponds, all things equal, to a 100 basis-point decline in US real GDP growth over the subsequent four quarters. The Goldman FCI has tightened by 212 bps since the start of the year and by 225 points from its loosest level in November 2021. If the relationship between the FCI and the economy holds, the tightening in financial conditions would be enough to push US growth to a below trend pace by Q2 of 2023. See Figure 1.

Figure 1

Similarly, the Chicago Fed’s Adjusted National FCI, which measures financial conditions relative to current economic conditions, has moved into restrictive territory. The index has been in expansionary territory since 2013, barring a brief period at the outset of the pandemic. See Figure 2.

Figure 2

What does this mean for the Federal Reserve and future rate hikes? Given that financial conditions have tightened and that growth expectations are lower, the Federal Reserve is likely to soften its tone. The Atlanta Fed President Raphael Bostic very recently suggested that the Fed could pause rate hikes in September to assess the impact of their tightening campaign. This was echoed by the Federal Reserve minutes from the last meeting which conveyed a sense of flexibility and date dependence about the timing and magnitude of future hikes once the rates reach 2%.

Financial conditions indices in the other major developed economies have tightened somewhat less than in the US because equities represent a smaller share of household net worth abroad and also because most currencies have weakened against the US dollar. With growth momentum having already deteriorated sharply, central banks are signalling a more balanced approach to policy normalisation.

The European Central Bank’s (ECB) president Christine Lagarde very recently provided a clear signal that the Eurozone policymakers are preparing to start raising interest rates. She observed that inflation expectations have risen from pre-pandemic levels, implying that real policy rates are currently lower than two years ago. Policy normalization in the Eurozone would mean ending net purchases under the Asset Purchase Program early in the third quarter, and possibly raising rates at both the July and September meetings which would bring rates back to zero from the present -0.5%. She noted further that the Euro Area is not facing a typical situation of excess aggregate demand or economic overheating. She noted that both consumption and investment remain below their pre-crisis levels, and even further below their pre-crisis trends. The market expects the ECB to raise rates by 170 bps over the next 12 months, bringing the deposit rate to 1.2% by mid-2023. See Figure 3.

Figure 3
The Bank of England (BOE) has hiked rates by 90 bps over the past 12 months. The UK Overnight Index Swap (OIS) curve is priced for a further 140 bps. According to the BOE’s forecasting model, this would raise the unemployment rate by 2% and lower inflation by 2%.

The situation in China is different. China faces problems on three fronts: a weakening housing market, slowing external demand for manufactured goods and the ongoing threat of covid-related lockdowns. As China struggles to grapple with the next outbreak, the authorities have responded with policy easing. The Peoples Bank of China lowered the 5-year loan prime rate by 15 bps last week.

Central Banks play an important role in the financial markets and their actions help provide direction for the value of their underlying currencies. Gauging the action of central banks can therefore be useful to investors. In summary, apart from China, global financial conditions have started to tighten in many economies. Accordingly, betting on ever-higher rates, at least for the next 12 months, no longer makes sense. If global inflation decelerates faster than anticipated during the remainder of the year, as we expect will be the case, central banks will dial back the hawkish rhetoric.

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