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OMG. Powell didn't push back against the easing of financial conditions you guys! I can't believe it. What's he gonna (not) do next?
We'll find out the answer to that question in a few hours when Powell speaks at the Economic Club of Washington (12:40EST/17:40 GMT).
So, you've probably seen variations of this chart in recent weeks 👇
That's the IMF version There's a few types. Bloomberg, Goldman Sachs, Chicago Fed etc. They're all generally pointing the same way. We wrote more on these Financial Conditions Indices back in December 👇
Much like stock market indices, these aggregates can sometimes hide what's happening under the surface. The weighting towards stock market performance is especially problematic.
Why do financial conditions matter?
Basically, the Fed (and all central banks) want tighter financial conditions to bring inflation down. Rate hikes should (eventually) encourage the public and businesses to slow spending, postpone investment and so on.
Ideally, a general malaise will set in, ensuring that we're all despondent enough about the future to be paralysed in the present. Scared money don't spend money.
Academics will argue endlessly over how monetary policy is transmitted through the economy. Like so much of the discipline, it's an unaswerable question. It varies. There will never be an empirical correct answer.
The outcome depends on all kinds of factors. Like the behaviours of billions of irrational human beings making decisions for all kinds of reasons that can't be modelled.
We had a perfect example in the chat, discussing someone who bought a property at a 10% discount from peak prices. They locked in a 30 year mortgage at 6.25%.
Now, it's easy to criticise that decision purely from a financial perspective.
But the main factor in the decision was making sure the family were in the right school zone. If rates drop back to 4% or so in the next couple of years, he's planning to refinance. If the 'house prices only go up' trend resumes, the 10% discount is a decent buffer.
It's a reasonable (not great) bet. But that misses the point. The most important takeaway is how the decision wasn't made primarily for financial reasons. The payoff (a better school) is immeasurable for economists. Now multiply that out across the global economy.
Getting back on track, the one consistent thing that does matter for the economy is trust and confidence. Eventually, fear overcomes hope. The reality of the present supercedes any optimistic stories of the future.
That's when the tightening really takes effect, and there are signs that's starting to happen...
Here's a boring title for you. The Senior Loan Officer Opinion Survey on Bank Lending Practices 🥱
Reuters has a good summary 👇
Lending officers at major banks told the Federal Reserve that in the final three months of last year they tightened standards and saw reduced demand across a wide array of business and consumer credit fronts.
The Fed reported Monday in its January Senior Loan Officer Opinion Survey that the threshold to get credit rose for commercial and industrial firms, as well as commercial real estate borrowers. At the same time, these prospective borrowers reduced their demand for loans.
As with all data, caveats apply. In this case, the fact that the SLOOS report is backwards looking may prove problematic. If animal spirits have truly been unleashed again for 2023 then this will all be for nowt.
But we probably shouldn't be too quick to dismiss this tightening of lending standards. It's a trend that usually leads to recessions 👇
Usually is doing some heavy lifting with a sample size of three recessions, but hopefully you get the point.
Tighter lending standards are likely to lead to economic slowdown: Less credit availability.
Lower demand for credit is also likely to lead to economic slowdown. Check out the tanking demand for auto loans... 👇
So why are credit markets so chilled? 👇
You'd expect junk bond spreads to be widening, but the soft landing is being credited (ha!) with keeping hope alive.
However, are we simply in the eye of the storm? 👇
Marty Fridson, chief investment officer at Livian Lehmann Fridson Investors, also predicted the gulf in yields between junk bonds and low-risk Treasuries to broaden. “You still have a lot of signs pointing to recession,” he said.
Spreads could increase by as much as two percentage points, Fridson added, “as that expectation starts to change from ‘everything’s fine, the Fed’s going to pivot, we’re going to have a soft landing’.”
“Historically, the high-yield market has not really anticipated recessions very well,” he said. It is “not unprecedented” for the market to be “ignoring the flashing yellow lights”.
Bloomberg had a chat with Dan Ivascyn, Pimco's Chief Investment Officer and added some forecasts there too 👇
The strength [in junk bonds] may be masking growing strains on balance sheets.
Moody’s Investors Service expects the global default rate for high-yield debt will rise to 5.1% in 2023, from 2.8% in 2022, as slowing growth and tougher financing conditions start to bite.
Bloomberg Intelligence says the increase in defaults may extend into 2024. Cracks are also emerging in loans to risky companies, with downgrades rising, and banks are setting aside more money to cover potential defaults.
“This cycle is going to be different,” Ivascyn said. “Even in a soft landing, we could see a scenario of multi-year disappointments in the credit markets” a drawn-out process marked by the restructuring of corporate debt and heightened losses.
When will the market decide that enough is enough and send the yield curve back to positive territory? 👇
Is this cycle really different? Can there be a soft landing?
Miracles are possible, but not probable.