Analysis: Markets face tougher financial conditions

May 9 (Reuters) – Already sitting on double-digit losses this year, stock market investors should prepare for more as awareness sinks in that the U.S. Federal Reserve intends to tighten financial conditions to control galloping inflation.

Essentially, financial conditions measure the ease with which households and businesses can access credit, so they are key in showing how monetary policy is transmitted to the economy. Fed boss Jerome Powell reiterated on Wednesday that he would be watching them closely.

And they affect future growth – Goldman Sachs estimates a 100 basis point tightening in its proprietary Financial Conditions Index (FCI) – which takes into account rates, credit and equity levels as well as the dollar – crushes growth by one percentage point over the following year.

Join now for FREE unlimited access to Reuters.com

Register

The Goldman indexes and other indexes from the Chicago Fed and the IMF all show that financial conditions have tightened considerably this year, but remain historically loose, indicating the extent of the stimulus measures triggered to help economies. overcome the pandemic.

Sven Jari Stehn, chief European economist at Goldman Sachs, believes the bank’s U.S. financial conditions index will need to tighten a little more for the Fed to achieve a “soft landing”, i.e. slow down growth but not excessively.

Goldman’s U.S. FCI is at 99 points – 200 basis points higher than at the start of the year and the tightest since July 2020. Conditions tightened 0.3 points on Thursday as stocks fell , 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 essentially needs to halve (the gap between jobs and workers) to try to get wage growth back to a more normal rate of growth,” Stehn said.

“To do that, they basically have 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 hikes of 50 basis points in June and July, then moves of 25 basis points until key rates rise to just above 3%. But if conditions don’t tighten enough and wage growth and inflation don’t moderate enough, the Fed could continue with 50 basis point hikes, he said.

The CFI’s looseness seems disconcerting given market bets that the Fed will raise rates above 3% by year-end while trimming its bond holdings, Treasury yields soaring and plummeting stocks.

But the S&P 500 is still trading 20% ​​above its pre-pandemic peak. Through the wealth effect, share prices should support household spending.

That could change – the Fed stopped expanding its balance sheet in March and will start shrinking it from June, possibly at a monthly rate of $95 billion, as it embarks on quantitative tightening (QT)

Michael Howell, managing director of advisory firm Crossborder Capital, noted that the decline in U.S. stocks followed a 14% drop in the Fed’s effective liquidity provision since December.

He estimates, based on pandemic stock market rallies and recent falls, that each monthly cut could drag the S&P 500 down 60 points.

The stock market is “certainly not pricing in a further reduction in liquidity, and we know that’s going to happen,” Howell said.

UNKNOWN TERRITORY

The question is whether the Fed can tighten conditions just enough to cool prices, but not so much that growth and markets are seriously hurt.

One risk – highlighted by Bank of England policymaker Catherine Mann – is that huge central bank balance sheets may have dampened the transmission of monetary policy to financial conditions.

If so, the Fed may need to act more aggressively than expected.

Mike Kelly, global head of multi-assets at PineBridge Investments, noted that past episodes of QT have been much smaller, so “we’re entering an environment that no one has seen before.”

In the QT exercises of 2013 and 2018, stocks fell 10%, forcing the Fed to ease its tightening. Read more

But those used to relying on the Fed’s “put”—the belief that it will step in and support stock markets—should be careful; Citi analysts believe this put option may not take effect until the S&P 500 takes another 20% drop.

“Where you have 8.5% inflation… the strike price of the central bank put option is much lower than it was before,” said Patrick Saner, head of macro strategy. at the insurer Swiss Re.

Join now for FREE unlimited access to Reuters.com

Register

Reporting by Yoruk Bahceli; edited by Sujata Rao; Editing by Louise Heavens

Our standards: The Thomson Reuters Trust Principles.

Comments are closed.