Economy: Financial conditions and the Fed put

| April 12, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Financial conditions tightened in late 2018, helping spark a sharp shift in Fed policy. Those tighter conditions (discussed here) broadly resembled market hiccups of mid- 2015 and early 2016 but fell well short of 1998, which ultimately resulted in 75 bp of Fed easing. Three months later, conditions have eased considerably with stock prices higher and risk spreads narrower even though Treasury yields remain well below last fall’s levels.  The shift in Fed policy should get some credit for the easier conditions, but the dance between the Fed and markets could get complicated if growth, as expected, starts to improve.

The Chicago Fed Financial Conditions Index

My favorite measure of financial conditions is the Chicago Fed’s National Financial Conditions Index (NFCI).  It includes more than 100 variables covering interest rate spreads, banks’ lending stance, liquidity measures, asset prices, and debt levels.  In a broad context, the tightening of financial conditions seen late last year registers as no more than a slight wiggle over the broad history of the series (Exhibit 1).  The current setting of financial conditions is about as easy as any going back to 1990.

Exhibit 1: Chicago Fed National Financial Conditions Index

Source: Chicago Fed.

The last six months for the NFCI represent virtually a perfectly symmetric round trip, as the NFCI went from a low (easiest financial conditions) of -0.84 in September to a high (tightest financial conditions) of -0.70 at the end of the year and, as of the latest reading (April 5), is back to -0.84, a 25-year extreme (Exhibit 2).

Exhibit 2: Chicago Fed National Financial Conditions Index

Note: the scale is reversed relative to the NFCI, as easy conditions are represented by positive readings and tight conditions by negative readings. Source: Chicago Fed.

Bloomberg Financial Conditions Index

To the extent that the Chicago Fed NFCI has a flaw, it is that it is so comprehensive that it sometimes is not timely as many of the series included are reported at a monthly or even a quarterly interval.  The Financial Conditions Index constructed by Bloomberg is an example of a more streamlined, but also timelier, gauge.  It only includes nine variables—TED spread, LIBOR/OIS spread, CP/T-bill spread, Baa/10-year Treasury spread, high yield/10-year Treasury spread, muni/10-year Treasury spread, swaption vol index, S&P 500 and the VIX index—and is calculated daily.  The FCI hit a post-financial-crisis-peak at +1.11 in early October, dropped to -1.11 on Christmas Eve and has rebounded to +0.87 as of April 11, recovering 89% of the tightening that occurred late last year (Exhibit 3).

Exhibit 3: Bloomberg Financial Conditions Index

Source: Bloomberg.

Credit for the Fed

It is fair to say that financial conditions have essentially returned to where they were before the noticeable tightening seen in the fourth quarter.  The narrative around that round trip, however, depends to a degree on who is telling the story.

One of the most interesting passages in the March FOMC minutes was this sentence: “participants observed that a good deal of the tightening over the latter part of last year in financial conditions had since been reversed; Federal Reserve communications since the beginning of this year were seen as an important contributor to the recent improvements in financial conditions.”  In other words, the FOMC wishes to take credit for the easing of financial conditions this year.  There is certainly some plausibility to this narrative, as the Fed has taken a starkly more dovish stance regarding the monetary policy outlook, with the median end-2019 dot projection moving from three hikes for 2019 in September 2018 to no change in March 2019.

Financial market expectations have shifted accordingly.  At the end of September, the January 2020 fed funds futures contract yielded 2.82%, versus a current reading of 2.24%.  At the same time, long-term interest rates have, if anything, moved even more.  The yield on 10-year Treasuries has declined from over 3.20% last October to around 2.50% now.  Thus, it would be hard to argue that the entire drop in long-term interest rates is a function of changing Fed expectations, but the FOMC can probably take credit for a sizable portion of the recovery.

It is probably more debatable whether the Fed can take credit for the recovery in stock prices and the narrowing in risk spreads.  Certainly, the sense that the Fed “has the markets’ back” played a role in the recovery in financial conditions in early 2019, but it is impossible to disentangle that factor from other relevant developments, such as the end of the federal government shutdown and the improved tone of U.S.–China trade negotiations.

Let’s accept for the sake of argument that the Fed can legitimately take credit for most of the recovery in financial conditions.  The next question is whether this is entirely a good thing.  Fed officials constantly object when market participants claim that there is a Powell Put (or, in the past, Greenspan put or Bernanke put or Yellen put), and yet the FOMC in the latest edition of the minutes seems to be trying to take credit for pretty much exactly that.  In any case, various indices suggest that financial conditions are about as easy as they have been at any time since at least the Financial Crisis.  That may seem appropriate at the moment, given downside risks that have financial markets worried and the fact that the economy apparently stumbled somewhat in terms of growth in the first quarter.

However, if, as I expect, economic growth recovers in the spring, as it has in prior years after habitually sub-par Q1’s, having such easy financial conditions might not look so good in a few months. Of course, financial conditions – and expectations with respect to the Fed — may change if the economic data improve.

Certainly, when the FCIs were hitting highs last year, there was a very real sense that financial markets were perhaps overheating.  We could find ourselves back there pretty quickly if there is a trade agreement and/or real GDP bounces back by more than expected in Q2.  In that scenario, it would be interesting to see how sluggish the Fed’s reaction function is, as the central bank historically has been notoriously slow to shift directions when the economy swings stronger or weaker, and whether the financial markets would jump out in front of the Fed or wait and take their cues from the FOMC.

john.killian@santander.us 1 (646) 776-7714

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