Markets Brief: What Does It Mean That Financial Conditions Are Tightening?

As the Federal Reserve nears the end of a historic cycle of interest rate increases, market watchers are anxiously eyeing evidence of how much those hikes have affected—or will continue to affect—markets and the economy.

That includes Fed chair Jerome Powell. “Financial conditions have tightened significantly in recent months,” he said in a speech at the Economic Club of New York on Thursday. In particular, Powell said, the recent jump in long-term bond yields has been an “important driving factor in this tightening.”

But when he referred to “financial conditions,” what did he mean? Earlier this year, Fed analysts defined such conditions as a “constellation of asset prices and interest rates” that change based on economic health and monetary policy, and which can also potentially affect the economy itself.

Measures of financial tightness (or looseness) provide a snapshot of the health of the economy and its prospects for growth in the months and years ahead. These are important tools for policymakers and investors alike.

These conditions include factors like bond yields, which serve as important benchmarks for mortgages and other consumer and business lending. The yield on the 10-year U.S. Treasury note has jumped to nearly 5%, up from just south of 4% at the end of July and the highest level since summer 2007. In the bond market, 73.1% of investors now expect the central bank to hold rates steady at its last meeting of the year in December, according to the CME FedWatch tool.

“The simplest way to put it,” says Joseph Briggs, an economist at Goldman Sachs, “is that when financial conditions tighten, it means the economy is probably going to slow down over the next year or so.”

Measuring Financial Conditions

With so many variables influencing the massive U.S. economy, quantifying changes is not easy. That’s why bank analysts use indexes that incorporate a wide variety of financial and economic data. The Federal Reserve Bank of Chicago has its own, as does Bloomberg. The Federal Reserve Board of Governors made headlines in June this year when it introduced its own.

Investors can think of these indexes as “scorecards” that account for the forces that affect the economy, businesses, and consumers, according to Mark Hackett, chief of investment research at Nationwide.

Among the most closely watched indexes on Wall Street is Goldman Sachs’ Financial Conditions Index. It uses five different variables: the nominal federal funds rate, the 10-year yield, credit spreads (the difference in yield between bonds of the same maturity but different quality), equity performance, and the value of the U.S. dollar against a basket of currencies weighted to the amount of trade the United States does with those countries.

Movement among those components can reflect potential changes to different aspects of the economy. For instance, the performance of the stock market can affect consumer spending and companies’ ability to raise capital, while higher interest rates will make it more expensive for consumers and businesses to borrow money.

Upward movement in the Goldman index means financial conditions are getting tighter. The steeper the curve, the faster that tightening is occurring. When the index slopes downward, financial conditions are getting looser. The Goldman index is weighted such that a one-point tightening is associated with a one-percentage-point slowdown in growth over the next year, Briggs explains. He says most of the impact on the U.S.’s growth prospects can be felt within the first two quarters after the index starts to tighten.

Briggs also emphasizes the importance of how the index moves relative to where it has been over time. It is currently sitting a little higher than 100, which is close to its historical average. That means conditions aren’t “exceptionally tight or exceptionally loose.” But more importantly, Briggs says, “we have seen an unusually large tightening in financial conditions” over the last two years or so.

The Growing Importance of Measuring Financial Conditions

Economists look at financial conditions because the federal funds rate alone isn’t sufficient for assessing the outlook for the economy.

“Financial markets act in expectation,” Briggs says, meaning conditions can become more or less accommodative based on how investors are anticipating the central bank’s next move. Oftentimes, that happens well before the Fed actually announces a rate decision. Analysts saw financial conditions tighten in the first half of 2022, he adds, “well before the Fed actually started hiking rates, once it became clear that inflation was going to be a problem.”

In the second half of that year, the Fed’s campaign to aggressively raise interest rates prompted a major slowdown in economic growth that customers are still feeling, especially in interest-rate-sensitive sectors like the housing market.

Briggs says measuring the broad spectrum of financial conditions has become even more important in the recent past as central banks have moved toward non-traditional policy tools. These include forward guidance on where they expect to take policy rates, as well as balance sheet policies like quantitative easing (a process in which the Fed purchases financial assets to stimulate economic growth). “The Financial Conditions Index can capture the totality of how all of these different financial variables are affecting the growth outlook,” he says.

The Implications of Tighter Financial Conditions

Investors shouldn’t lose sleep if they see financial conditions continuing to tighten. The old adage that “the stock market isn’t the economy” holds true here.

“Historically, the tightest decile of financial conditions has among the best forward 12-month equity market returns,” Hackett says. He points to the recent past as an example: Financial conditions were significantly tighter a year ago, but equities have rallied roughly 20% since then.

“When financial conditions are at the tightest, that’s the most stressed the market could be,” Hackett says. “Once things start loosening, that’s good for the market.” As a result, Hackett says investors should view measures of financial conditions “as a tool to understand what’s going on” in the economy, rather than a predictor of portfolio performance.

For the Trading Week Ended Oct. 20

• The Morningstar US Market Index fell 2.4%.
• The best-performing sectors were consumer defensive, up 0.66%, and energy, up 0.50%.
• The worst-performing sector was real estate, down 4.2%.
• Yields on 10-year U.S. Treasury notes rose to 4.92% from 4.63%.
• West Texas Intermediate crude prices rose 1.21% to $88.75 per barrel.
• Of the 852 U.S.-listed companies covered by Morningstar, 196, or 23%, were up, and 656, or 77%, were down.

What Stocks Are Up?

Kohl’s KSS, Netflix NFLX, and Under Armour UAA.

What Stocks Are Down?

SolarEdge Technologies SEDG, Enphase Energy ENPH, and Moderna MRNA.