At last week’s FOMC meeting, Jerome Powell said, “We think financial conditions are weighing on the economy.”
His comments seem sensible, given the following:
- The Fed is reducing its balance sheet (QT).
- The Fed funds rate is at its highest level in over 15 years.
- Mortgage rates are about 7%, 3-4% above pre-pandemic levels.
- Credit card interest rates are 20% or more.
- Auto loans range between 7% and 10%
- Consumer-loan growth, excluding the pandemic, is down to levels last seen over ten years ago.
- Outstanding commercial and industrial (C&I) loans are declining.
Powell’s statement indicates that financial conditions are tight. But they are easy based on the Fed’s definition of financial conditions. If Powell doesn’t appreciate the difference between financial and borrowing conditions, we must assume most investors do not either.
As I will explain, there is a big difference between financial and borrowing conditions. Easy financial conditions and tight borrowing conditions make monetary policy difficult for the Fed to balance.
What are financial conditions?
The St. Louis Federal Reserve defines financial conditions as follows:
Measures of equity prices (also commonly referred to as stock prices), the strength of the U.S. dollar, market volatility, credit spreads, long-term interest rates, and other variables.
Financial conditions tend to be easy when investors are optimistic and speculative. Let’s look at the five critical measures in the St. Louis Fed definition to understand why financial conditions are easy today.;
- Equity prices: The S&P 500 is up 38% since 2023 and 10% through the first three months of 2024.
- U.S. dollar: The dollar index has been relatively flat since 2023 and the year to date.
- Market volatility: The VIX volatility index has been hovering between 12 and 15 this year. That is about one standard deviation below the average VIX reading of 19.32 over the last 35 years.
- Credit spreads: The BBB investment-grade yield is only 1% above a comparable maturity Treasury. That is the tightest spread since the 1990s.
- Long-term interest rates: Long-term interest rates have been significantly higher than average over the past few years and at levels last seen before the financial crisis in 2008. But they are about 1% lower than their peak last year.
Equity prices, market volatility, and credit spreads point to very easy financial conditions, and we might also characterize their levels as speculative.
The dollar has had little effect on financial conditions as it has been relatively stable.
Long-term interest rates point to tighter financial conditions, albeit easing over the past six months.
Financial conditions are easy in large part because robust sentiment in the equity and credit markets more than offsets higher interest rates.
As shown below, my firm’s proprietary SimpleVisor Sentiment indicator is at its maximum level, and the CNN Fear & Greed Index is closing in on extreme greed.
Read the full article here by Michael Lebowitz, Advisor Perspectives
