With the Fed dead set to hike 25bps next week, a question has emerged across trading desks: Why? The Ukraine war has led to such a dramatic tightening of global financial conditions, that one can argue there is no longer a pressing need for the Fed to hike. In fact, any further tightening here will only accelerate a global recession.
As the following chart from Goldman Sachs, which compiles the most widely used financial conditions indexes, shows, financial conditions are at the tightest in two years, driven by soaring energy prices, sliding stocks and the market fallout from the Ukraine-Russia conflict. In fact, if one excludes the March 2020 chaos, the last time financial conditions were this tight, the Fed Funds rate was about to hit the past cycle high of 2.50%.
As the bank further shows, the biggest drivers behind the sharp move are substantially higher global rates and wider credit spreads.
The bank has shown that a 100-basis-point tightening crimps growth by one percentage point in the coming year, with an equivalent loosening giving a corresponding boost.
Global financial conditions – an umbrella phrase for how metrics such as exchange rates, equity swings and borrowing costs affect the availability of funding in the economy – and perceived as strongly correlated with future growth . How loose or tight conditions are dictate spending, saving and investment plans of businesses and households.
The tightening is an unwelcome development for a world economy already threatened by the fallout from $120-a-barrel oil prices and supply chain setbacks caused by sanctions on Russia. If these drive inflation steadily higher, and “if the central banks take their mandates seriously, you will see a further (tightening) in financial conditions,” said Rene Albrecht, strategist at DZ Bank.
“Economic dynamics will slow down further, inflation will be high nonetheless and you will see second round effects and then you get a stagflation scenario,” he added, referring to a combination of rising inflation and slower economic growth.
While the rise was led by its Russian FCI, which rose as high as 114.8 from around 98 at the start of February to the tightest since the 2008 crisis, driven by a doubling of interest rates and a market implosion, Euro zone moves were sizeable too. Conditions in the bloc, heavily reliant on Russian energy, are at the tightest since November 2020, having moved 50 bps in February, driven also by the European Central Bank (ECB) opening the door to rate hikes this year.
Speaking to Reuters, Viraj Patel, global macro strategist at Vanda Research, said financial conditions would take on even more importance for the ECB, which meets on Thursday.
Should it proceed with the unwinding of bond purchases followed by rate hikes as expected before the invasion, financial conditions could tighten to levels seen at the height of the pandemic or even the bloc’s sovereign debt crisis a decade ago, he added.
The good news is that for now US financial conditions have tightened to a lesser extent. But the indicators Goldman uses to calculate its indexes signal no relief; safe-haven flows are boosting the U.S. dollar, which is near two-year highs, and world stocks have fallen 11% this year, led by a near-20% fall in euro zone equities. U.S. investment-grade corporate bond risk premia have widened 40 bps year-to-date as investors assess the hit to companies’ profits.
Still, despite the sharp tightening in financial conditions, the Fed will still tighten as its primary mandate now – as Joe Biden makes very clear at every opportunity – is to contain inflation, although how a supply shock can be fixed with a targeted economic slowdown is unclear. One thing that is rather clear is that any progressive tightening by the Fed will only push the global economy faster into recession, something the yield curve – which has collapsed to just over 20bps – is making very clear.