Breaking News
Get Actionable Insights with InvestingPro+: Start 7 Day FREE Trial Register here
Investing Pro 0
Ad-Free Version. Upgrade your experience. Save up to 40% More details

Analysis: Markets must face up to tightening financial conditions

Economy May 09, 2022 02:45AM ET
Saved. See Saved Items.
This article has already been saved in your Saved Items
© Reuters. A specialist trader works inside his post on the floor of the New York Stock Exchange (NYSE) in New York City, U.S., March 10, 2022. REUTERS/Brendan McDermid/Files

By Yoruk Bahceli

(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 (NYSE:GS) 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.

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.


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.

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 (OTC:SSREY).

Analysis: Markets must face up to tightening financial conditions

Related Articles

Add a Comment

Comment Guidelines

We encourage you to use comments to engage with other users, share your perspective and ask questions of authors and each other. However, in order to maintain the high level of discourse we’ve all come to value and expect, please keep the following criteria in mind:  

  •            Enrich the conversation, don’t trash it.

  •           Stay focused and on track. Only post material that’s relevant to the topic being discussed. 

  •           Be respectful. Even negative opinions can be framed positively and diplomatically. Avoid profanity, slander or personal attacks directed at an author or another user. Racism, sexism and other forms of discrimination will not be tolerated.

  • Use standard writing style. Include punctuation and upper and lower cases. Comments that are written in all caps and contain excessive use of symbols will be removed.
  • NOTE: Spam and/or promotional messages and comments containing links will be removed. Phone numbers, email addresses, links to personal or business websites, Skype/Telegram/WhatsApp etc. addresses (including links to groups) will also be removed; self-promotional material or business-related solicitations or PR (ie, contact me for signals/advice etc.), and/or any other comment that contains personal contact specifcs or advertising will be removed as well. In addition, any of the above-mentioned violations may result in suspension of your account.
  • Doxxing. We do not allow any sharing of private or personal contact or other information about any individual or organization. This will result in immediate suspension of the commentor and his or her account.
  • Don’t monopolize the conversation. We appreciate passion and conviction, but we also strongly believe in giving everyone a chance to air their point of view. Therefore, in addition to civil interaction, we expect commenters to offer their opinions succinctly and thoughtfully, but not so repeatedly that others are annoyed or offended. If we receive complaints about individuals who take over a thread or forum, we reserve the right to ban them from the site, without recourse.
  • Only English comments will be allowed.

Perpetrators of spam or abuse will be deleted from the site and prohibited from future registration at’s discretion.

Write your thoughts here
Are you sure you want to delete this chart?
Post also to:
Replace the attached chart with a new chart ?
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Thanks for your comment. Please note that all comments are pending until approved by our moderators. It may therefore take some time before it appears on our website.
Comments (1)
Gary Smith
Gary Smith May 09, 2022 2:23AM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
another speculation filled piece.
Are you sure you want to delete this chart?
Replace the attached chart with a new chart ?
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Add Chart to Comment
Confirm Block

Are you sure you want to block %USER_NAME%?

By doing so, you and %USER_NAME% will not be able to see any of each other's's posts.

%USER_NAME% was successfully added to your Block List

Since you’ve just unblocked this person, you must wait 48 hours before renewing the block.

Report this comment

I feel that this comment is:

Comment flagged

Thank You!

Your report has been sent to our moderators for review
Continue with Google
Sign up with Email