Financial Conditions Are Rapidly Tightening
Tighter Monetary Policy is Dramatically Affecting the Financial Sphere
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The Federal Reserve is aggressively tightening monetary policy in order to constrain inflation. This month—after delaying the move in due in part to the Russian invasion of Ukraine—the Federal Open Market Committee (FOMC) voted to raise interest rates by 0.5% for the first time in 20 years. Though Jerome Powell has ruled out 0.75% hikes at future meetings, he has indicated an extremely tight monetary policy stance relative to earlier in the pandemic.
Back in March, I wrote that financial conditions were tightening even before the FOMC officially raised interest rates due to the credible signal of upcoming tighter monetary policy. Since then, conditions have only gotten tighter: real interest rates are rising, corporate credit spreads are up, and equity risk premiums are higher. The result has so far been close to what the Fed was intending—a drop in inflation expectations and early signs of a price slowdown. However, the full effects of tighter monetary policy have not yet worked their way through the economy—and it will be critical to watch for shifts in the financial sphere as we enter the next stage of the economic recovery.
The Chicago Fed’s National Financial Conditions Index (NFCI) blends a variety of banking and financial datapoints to construct a single measurement of the relative tightness of financial conditions. A lower number indicates looser conditions—where companies, banks, and consumers are able to easily borrow and raise money—and higher numbers indicate tighter conditions—where the opposite is true. Normally the index proves fairly unremarkable as financial conditions do not change much outside of periods of extreme financial stress (such as the 2008 recession) or when monetary policy rapidly tightens (as in the late 90s-early 00s, mid 2010s, or right now).
In early 2020 we got tighter financial conditions from extreme financial stress as a result of the pandemic. Today we are seeing tighter financial conditions from explicit shifts in monetary policy; excluding the early pandemic, this week the NFCI notched its highest level since the Euro crisis of 2011. The NFCI credit subindex is only marginally tighter than before the pandemic, but the risk subindex (which tries to capture volatility and funding risk in the financial sector) has rapidly shot up and is approaching its early-COVID levels. The biggest contributors to the rise in the risk subindex are stock market volatility, interest rate volatility, and rising spreads between Treasury bonds and interest rate swaps. In other words, uncertainty around interest rates and the stance of monetary policy are contributing significantly to tightening financial conditions.
At some level, though, the Fed is getting what it wants; real interest rates are rising and inflation expectations are falling. Nominal 5 year Treasury yields increased 150 basis points from the beginning of the year to their peak in early May, and almost all of that increase came from a rapid rise in real interest rates. Breakeven inflation expectations started the year at 3%, jumped 60 basis points by late March, and then sank back down to 3%. The rapid jumps in real interest rates (150 basis points from March to now) have dragged inflation expectations back down after the Russian invasion of Ukraine shot them to record highs. That leaves breakeven expectations at 2.9% right now, high by historical standards but not far outside the 2.3%-2.7% range that would be consistent with the Fed’s long run inflation target. Keep in mind that these numbers don’t just reflect current interest rates—they incorporate expected future interest rates and general expected stance of monetary policy.
High yield Corporate bond spreads—which essentially measure the perceived chance of corporate default for the riskiest companies and how difficult it is for them to borrow money—have followed a similar pattern to real interest rates. After rising through March, they briefly declined after the Federal Reserve temporarily stalled its aggressive monetary tightening. Then they bounced back up to new highs as Powell resumed tightening policy. Keep in mind that high yield bond spreads likely understate how tight financial conditions are because energy companies are overrepresented among high-yield issuers—recent jumps in oil and other energy prices are keeping related companies afloat, pushing down spreads in high-yield bonds.
Even still, spreads are nowhere near as high as they were in the aftermath of the financial crisis, early COVID, or even the mid 2010s (when monetary tightening mixed with a massive drop in energy prices). The closest comparable point is late 2018/early 2019, when the Fed was tightening policy until a weakening economy caused it to back off.
Then, of course, there is the stock market. As of writing, the S&P 500 is down 13% year-to-date—but the index was down more than 20% at its lowest. Rising interest rates are curbing valuations, a worsening geopolitical outlook is cutting some growth estimates, and margin pressures might start constraining earnings—but some of the dip in share prices comes from a rising equity risk premium. If financial conditions are tightening—and they are—the relative risk of equity ownership would be rising, and share prices could take a tumble. That’s making it harder for companies to raise money and justify large expansions—and we’re already seeing the hardest-hit companies (mostly in the nonrepresentative sample of high growth tech firms like Netflix, Peloton, and Carvana) announce that they’re trimming workforces and reducing growth plans.
All this data also makes it clear how much the decision to not raise interest rates by 0.5% just after Russia invaded Ukraine (and the Fed’s decision to hold off on tightening monetary policy) ended up temporarily loosening financial conditions. Share prices increased, bond spreads shrank, real interest rates dipped, and inflation expectations rose in response.
Finally, mortgage rates are surging and the average 30-year fixed mortgage rate briefly touched the highest levels since 2009. Mortgage rates are rising far faster than treasury yields, driving the spread between the two up significantly. Calculations of option-adjusted mortgage spreads (which are harder to create than the option-adjusted corporate bond spreads I referenced earlier) show levels equivalent to post-financial crisis highs. That’s partially reflecting the enormous amount of current interest rate volatility—which mortgage backed securities are more sensitive to. Either way, a rate surge this large will throw some cold water on the housing market even if home prices do not come down.
The Federal Reserve’s pivot over the last six months has been aggressive—and represents arguably one of the fastest instances of intentional monetary tightening over the last 30 years. It’s natural that financial conditions would worsen significantly in response—and indeed it was likely a necessary (whether intentional or not) downstream consequence of such a pivot.
The good news is that there are some early signs that monetary policy expectations are stabilizing. Nominal yields on treasuries with maturities between 1-10 years have either stabilized or shrank over the past month—and the same is true for real yields. In the Fed’s ideal world, the current path of monetary policy should be enough to get inflation under control without too much adverse impacts on real economic growth. Whether they’re right or not, financial conditions will remain critical to watch going forward.
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