Take it easy: central bank U-turns loosen financial conditions

By Sujata Rao

(Reuters) - Rate cut bets and rallying equity and bond markets are feeding into a gradual loosening of financial market conditions that could potentially send world growth ticking higher by the end of the year, a closely watched index suggests.

Financial conditions are crucial for economic activity because they often dictate the spending, saving and investment plans of businesses and families and an index (FCI) compiled by Goldman Sachs (NYSE:GS) suggests an improving picture since the start of 2019 in the United States and worldwide.

(For an interactive version of the chart click https://tmsnrt.rs/2NZACg9)

"Since June, financial conditions have been easing and in the United States they are back where they were at the start of the fourth quarter," said Sven Jari Stehn, head of Europe economics at Goldman Sachs.

The easing was precipitated by the U.S. Federal Reserve's dovish pivot in January and while an escalation in Sino-U.S. trade tensions briefly sent the index higher in May, conditions loosened again in June as the Fed and European Central Bank re-ignited equity and bond market rallies by flagging rate cuts.

The dollar, another key determinant of global financial conditions, has also slipped off two-year highs hit in May.

Goldman's FCI indexes are constructed as a weighted average of components including equity moves, long-dated borrowing costs, credit spreads and trade-weighted exchange rates.

They have a strong historical correlation with economic growth, according to Goldman, which says that a 100 basis-point tightening in conditions tends to crimp growth by around one percentage point over the coming year and vice versa.

Tight conditions following December's equity sell-off and trade-war noise hurt world growth early in 2019 but Stehn said recent loosening could help bring about a recovery -- if central banks deliver the stimulus markets expect.

"The negative effect is diminishing and towards the end of the year it should turn into a boost for U.S. growth," he said.

The Fed is expected to cut rates by 25 basis points at its meeting in late July, and a September rate cut from the ECB is priced in by markets.

Just how much more money could central banks pump into world markets?

Pictet fund manager Steve Donze says current 3,000-point levels on the S&P 500 imply up to $1.7 trillion more will be injected by the biggest central banks -- the Fed, ECB, Bank of England, People's Bank of China and Bank of Japan.

The first step will be the Fed ending its balance sheet normalization at the end of September. So far it has allowed its bond holdings to fall by as much as $50 billion a month.

Donze estimates the current liquidity flow from the big five central banks at 8.6% of global GDP, versus a 10.4% average since the crisis, but the upcoming Fed balance sheet shift should raise it to 9.6%.

"Last year you had a relentless liquidity squeeze which culminated in the capitulation of the Fed and China," Donze said. "It's an illustration of the Powell Put -- basically they are saying 'we are intervening to make sure liquidity levels don't fall any more'."

(Reporting and graphic by Sujata Rao; Editing by Toby Chopra)