Already standing on double-digit losses this year, stock market investors must get ready for more, as the realization registers that the U.S. Federal Reserve plans to tighten financial conditions to be in control of the red-hot inflation.
Financial conditions essentially measure how easily businesses and households can acquire credit. So, they are significant in showing how monetary policy transmits to the economy. On May 4, Fed boss Jerome Powell reiterated his stand insisting that he will be observing all these factors.
They also have relevance to future growth – Goldman Sachs approximates a 100 basis-point tightening in its proprietary financial conditions index (FCI) – which factors in equity and credit levels, rates as well as the dollar – crimps growth by 1% over the following year.
Goldman’s and other indexes from IMF and the Chicago Fed all suggest that financial conditions have become significantly tough in 2022 but remain loose historically. That is a testament to the scale of stimulus released to help economies survive through the pandemic.
Chief European economist at Goldman Sachs, Sven Jari Stehn estimates the bank’s financial conditions index will need to tighten a bit further for the Fed to achieve a “soft landing”, i.e. to slow growth but not extensively.
The FCI for Goldman is at 99 points – 200 bps tighter than at the beginning of 2022 and the tightest since July 2021. On Thursday last week, conditions tightened 0.3 points as the dollar hit two-decade highs, shares plunged, and 10-year bond yields closed above 3%.
However, they still remain historically loose. Stehn said:
“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. 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 foresees 50 bps hikes in June and July, then 25 bps moves until policy rates grow just above 3%. Nevertheless, if wage growth and inflation do not moderate sufficiently and conditions do not tighten enough, the Fed may proceed with 50 bps hikes.
The loose nature of FCI seems unclear given that the market bets that the Fed will raise rates above 3% by year-end while knocking over its bond holdings, tumbling stocks, and sharply higher Treasury yields. The S&P 500, however, still trades 20% above its pre-pandemic peak. Equity prices are presumed to support household spending through the wealth effect.
That might change – the Fed stopped expanding its balance sheet in March and will resume trimming it from June, eventually at a monthly $95 billion rate, embarking on quantitative tightening (QT). U.S. equity declines have trailed a 14% fall in effective liquidity provision by the Fed since December, said Michael Howell, managing director at consultancy Crossborder Capital.
Howell estimates, based on pandemic-time stock rallies and recent tumbles, sixty points could be knocked off the S&P 500 by each monthly reduction. He added:
“The stock market is certainly not discounting any further reduction in liquidity, and we know that’s going to happen.”
For now, the main question is whether the Fed can tighten conditions just enough to refresh prices but not so much that markets and growth are seriously crushed.
Bank of England policymaker Catherine Mann emphasized on a risk which is that central banks’ large balance sheets may have softened the transmission of monetary policy into financial conditions. If so, the Fed may need to act more aggressively than predicted.
Mike Kelly, head of global multi-asset at PineBridge Investments, stated that previous QT episodes had been much smaller so:
“We are going into an environment that no one’s ever seen before.”
Stocks fell by 10% during the QT exercises of 2013 and 2018, making the Fed lessen its tightening rate. Nonetheless, those who are always depending on the Fed “put” – the belief it will step in and restrain markets – should look out; Citi analysts reckon this put may not set in before the S&P 500 endures another 20% fall.
Patrick Saner, head of macro strategy at insurer Swiss Re, stated:
“Where you have 8.5% inflation… the strike price of the central bank put option is a lot lower than it used to be.”