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The Fed, and other central banks are obsessing over 'financial conditions'. Even after tightening at breakneck speeds, financial conditions have eased. That won't last.
As with many market terms, financial conditions sounds boring and far too generic to really matter. Which is sort of correct. FC's are boring. But they really do matter.
There's a few different indices out there measuring different things to define Financial Conditions 👇
Relax. We're not going to dig too far into these here. The long and short of it is some combination of risk appetite plus the cost of taking risk (via lending & borrowing) over different time horizons.
On a really basic level, when people don't want to lend and/or people don't want to borrow, that creates tighter financial conditions. It's not typically just about the desire to lend/borrow, it's also about the relative cost of borrowing and the return that a lender demands...
Can the borrower afford to borrow? Will the lender get the return? What's the correct price for both parties to take that risk?
Then there's risk appetite: how willing people are to put money to work in the stock market, high yield credit and private equity 👇
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.
Let's put this into current context.
Financial conditions 'easing'
In their Fed preview, Goldman pointed out the two way path of tightening financial conditions 👇
At the last FOMC meeting, Chair Powell seemingly wanted to offset the news of slower hikes by simultaneously emphasizing that the terminal rate will probably go higher than previously anticipated. This might have been an attempt to avoid sending too much of an easing signal to markets.
While that worked on the day of the meeting, financial conditions have now eased materially in the ensuing weeks. But this should not come as a surprise. It is tempting to assume that delivering rate hikes and guiding relatively close to market pricing should be neutral for financial conditions, but it is not so simple.
This type of guidance tends to ease financial conditions through several important channels. In fact, with the Fed clearly uncomfortable moving at this extraordinary pace, this has been happening all year...
The overall upwards trend means that conditions are tightening, punctuated by periods of easing along the way. Just like any market, we have trends and pullbacks.
It's easier to visualise using the Chicago Fed's Index 👇
The recent 'easing' came up in Powell's presser yesterday 👇
Over the course of the year, financial conditions have tightened significantly in response to our policy actions. Financial conditions fluctuate in the short term in response to many factors, but it is important that over time they reflect the policy restraint we are putting in place to return inflation to 2 percent.
We are seeing the effects on demand in the most interest-sensitive sectors of the economy, such as housing. It will take time, however, for the full effects of monetary restraint to be realized, especially on inflation.
Why Should I Care?
Because we're moving into the pain zone. Inflation's coming down, markets want the Fed to take notice. The Fed DGAF. This headline sums up the conflict beautifully 👇
This tension between the market and the Fed will persist. At least until inflation slows enough to satisfy the central bankers that prices won't surge the first time they even glance at the words 'rate cut'...
This dissent and disagreement is perfectly illustrated by Mr @effmkthype here 👇
For 2022, the Fed and the market basically agreed.
For 2023, the market sees cuts, the Fed sees higher for longer.
Looking further out 👇
Green = Fed dot plot (median projections)
White = Fed fund futures
Purple = Overnight Index Swaps
Basically, the green is what the Fed thinks, the other two are what 'the market' thinks. They're probably both wrong to some extent. The point is that they disagree.
It's at times like this, financial conditions really start to tighten. The deeply inverted curves we currently see are the first step.
Then the curve flattens as the economy slows. Credit markets freeze up due to a combination of fears about the economic future or because lenders aren't sufficiently compensated for taking on the risk of lending for a long duration.
(e.g. why lend for ten years at a lower rate than lending for two years?)
Which is why we say this curve is so important...
The end effect is the same. Recession. The depth of the downturn is TBD, but it looks inevitable for 2023.
Central banks are already downgrading their economic growth forecasts for the next year. The bad news? They usually underestimate the severity of the downturn...
Anything can happen. If inflation keeps falling at the current pace, they might be cutting rates again before we know it. Maybe that soft landing can be pulled off.
It's low odds they'll be responsive enough though. Generals always fighting the last war...