Analysis: Markets must face up to tightening financial conditions

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May 9 (Reuters) – Already sitting on double-digit losses this year, stock market investors must brace for more, as the realisation sinks in that the U.S. Federal Reserve intends to tighten financial conditions to get on top of red-hot inflation.

Essentially, financial conditions measure how easily households and businesses can access credit, so are critical in showing how monetary policy transmits to the economy. Fed boss Jerome Powell repeated on Wednesday he will be keeping a close eye on them.

And they have a bearing on future growth – Goldman Sachs estimates a 100 basis-point tightening in its proprietary financial conditions index (FCI) – which factors in rates, credit and equity levels as well as the dollar – crimps growth by one percentage point over the following year.

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Goldman’s and other indexes from the Chicago Fed and IMF all show financial conditions have tightened significantly this year but remain loose historically, a testament to the scale of stimulus unleashed to help economies weather the pandemic.

Sven Jari Stehn, chief European economist at Goldman Sachs, estimates the bank’s U.S. financial conditions index will need to tighten somewhat further for the Fed to achieve a “soft landing”, i.e. to slow growth but not excessively.

Goldman’s U.S. FCI is at 99 points – 200 bps tighter than at the start of the year and the tightest since July 2020. Conditions tightened 0.3 points on Thursday, as shares tanked, the dollar hit two-decade highs and 10-year bond yields closed above 3%.

But they still remain historically loose.

“Our estimate is that the Fed basically needs to halve (the jobs-workers gap) to try to get wage growth back to a more normal growth rate,” Stehn said.

“To do that they essentially need to reduce growth to a rate of around 1% for a year or two, so you have to go below trend for a year or two.”

He expects 50 bps hikes in June and July, then 25 bps moves until policy rates rise just above 3%. But if conditions do not tighten enough and wage growth and inflation do not moderate sufficiently, the Fed may continue with 50 bps hikes, he said.

FCI looseness appears puzzling given market bets that the Fed will lift rates above 3% by year-end while running down its bond holdings, sharply higher Treasury yields and tumbling stocks.

But the S&P 500 still trades 20% above its pre-pandemic peak. Through the wealth effect, equity prices are thought to support household spending.

That may change – the Fed stopped growing its balance sheet in March and will start cutting it from June, eventually at a monthly $95 billion rate, embarking on quantitative tightening (QT)

Michael Howell, managing director at consultancy Crossborder Capital, noted that U.S. equity declines have tracked a 14% drop in effective liquidity provision by the Fed since December.

He estimates, based on pandemic-time stock rallies and recent falls, each monthly reduction could knock 60 points off the S&P 500.

The stock market “is certainly not discounting any further reduction in liquidity, and we know that’s going to happen,” Howell said.

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The question is whether the Fed can tighten conditions just enough to cool prices but not so much that growth and markets are seriously hit.

A risk – highlighted by Bank of England policymaker Catherine Mann – is that central banks’ huge balance sheets may have muted transmission of monetary policy into financial conditions.

If so, the Fed may need to act more aggressively than expected.

Mike Kelly, head of global multi-asset at PineBridge Investments, noted that past QT episodes had been far smaller so “we are going into an environment that no one’s ever seen before.”

During the QT exercises of 2013 and 2018, stocks tanked 10%, forcing the Fed to ease back on tightening. read more

But those used to relying on the Fed “put” – the belief it will step in and backstop stock markets – should watch out; Citi analysts reckon this put may not kick in before the S&P 500 endures another 20% fall.

“Where you have 8.5% inflation… the strike price of the central bank put option is a lot lower than it used to be,” said Patrick Saner, head of macro strategy at insurer Swiss Re.

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Reporting by Yoruk Bahceli; editing by Sujata Rao; Editing by Louise Heavens

Our Standards: The Thomson Reuters Trust Principles.

https://www.reuters.com/business/finance/global-markets-financial-conditions-analysis-pix-2022-05-09/