U.S. financial conditions have tightened significantly since risk assets began to falter in the summer. Why does this matter for investors? Financial conditions describe how changes in financial asset prices impact economic growth. The more they tighten, the more they weigh on economic growth. The more they ease, the more they boost growth. But financial conditions are tough to measure.
Common gauges—which include interest rates, market volatility and asset valuations—can give misleading results. This is because unadjusted financial asset prices tend to both reflect growth news as well as drive growth news. Take the following example: Rising U.S. growth expectations can push up yields and the dollar. This could lead to the deceptive conclusion that financial conditions are tightening and the growth outlook is deteriorating. Most common gauges account for the impact of the business cycle thus far on financial asset prices, but they do not account for the fact that current economic expectations also affect today’s asset prices and hence financial conditions.
Financial Conditions Indicator (FCI)
Our latest Macro and market perspectives, A tale of tighter conditions, introduces our Financial Conditions Indicator (FCI)–a better gauge of financial conditions, we believe, than common measurements. Our new FCI seeks to avoid the problem of common gauges by fully stripping out the impact of growth news on asset prices from the underlying asset prices for government bonds, corporate credit, equity markets and the exchange rate. Once the forward-looking factor is also removed, our FCI behaves more closely in line with economic theory. Case in point: an increase in interest rates and yields following better growth news does not lead to an assessment by our metric that financial conditions have tightened.
Our FCI provides a measure of the impact that financial conditions are exerting on the growth outlook–as proxied by the BlackRock Growth GPS–and not the impact of the current growth outlook on financial conditions. Its inputs include policy rates, bond yields, corporate bond spreads, equity market valuations and exchange rates.
What is our new FCI telling us?
It shows financial conditions in the U.S. and in the euro-zone are tightening. Moves in our FCI have historically led our growth GPS by around six months. Tighter financial conditions suggest that growth in the U.S. will likely decelerate in the coming twelve months. See the Tighter times chart.
All other things equal, this implies slowing, but above-trend global growth in 2019, we believe. The sell-off in financial markets since the summer and ongoing Fed policy tightening would be consistent with U.S. gross domestic product (GDP) growth slowing to just under 2.5% next year from almost 3% now. The market sell-off since September has alone caused a tightening in financial conditions equivalent to a 35 basis point decline in the U.S. Growth GPS.
What does our FCI say about monetary policy?
In September the median Fed projection was for four more rate hikes by the end of 2019. Our FCI suggests this would tighten financial conditions enough to arrive at 2% growth by 2020–assuming that no other factors weigh on growth. But the fading fiscal stimulus boost–which alone could lower U.S. GDP growth by 25-75 basis points, according to our estimates–and elevated trade tensions will likely also weigh on growth, reducing the scope for Fed rate hikes, we believe. And another financial market sell-off could further tighten financial conditions.
We believe monetary policy tightening–beyond that priced by the market–would only be required to engineer a “soft landing” if no other headwinds slow growth down to around 2%. Growth at 2% is the level that we and the Fed believe to be sustainable because it is closer to the pace of growth of potential output.
In the euro-zone, our FCI suggests a substantial slowdown in GDP growth to less than 1.5% next year–financial conditions are already tight enough for growth to moderate to a level close to potential. We believe this implies that the European Central Bank (ECB) may decide to keep interest rates at record lows for most of 2019. But fiscal stimulus by several member states could also support euro-zone growth, potentially changing the picture for the ECB.
Our FCI–like other daily gauges of financial conditions–is currently based on a small set of financial market variables so it can be updated on a daily basis. But financial conditions are also represented by other information that includes surveys of credit conditions, interest rates charged and paid by banks, and the amount of financing that is being made available to the private sector. These factors should also be considered in assessing financial conditions. Read more on our research in our latest Macro and market perspectives.