About two weeks ago, I started brainstorming the topic of this blog post. In my first draft, I started the piece by stating, “no one cares about financial conditions anymore.” This is because when conditions are easy, you don’t hear much about them. But clearly, my post was “leaked” because this week financial conditions indices (FCIs) are the topic du-jour! The headline risks emanating daily from Washington, D.C., have quickly brought this topic back into the spotlight.
But first, let’s put the recent experience of this year 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 breakevens declined to post-crisis lows. Last year, the market narrative was fear of a recession in the United States, a hard landing in China, and a global growth meltdown. At that time, market strategists were quoting measures of financial stress and their paralyzing effect on markets and central banks. In the first quarter of 2017, market strategists didn’t seem interested in FCIs.
I want to explain why we should be monitoring financial conditions both when they are in vogue (which typically is the case when conditions tighten sharply) as well as when they are not. Here are three reasons:
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. Ultimately, 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 but instead by the magnitude and the pace at which financial conditions tighten or loosen.