All Else Equal

Lost in the cacophony of apocalyptic Fed pontificating is one simple reality: Financial conditions have never been easier.

The proximate cause of recent consternation across risk assets is the surge in US real rates, which Goldman’s David Kostin described as “stunning” in his latest missive.

There was some relief on Friday. 10-year reals fell 9bps, but remained 45bps less negative than they were at the end of last year. That represents a significant tightening impulse. Relatively heavy losses for US tech shares reflect that.

Nevertheless, it’s important to keep perspective, especially considering market participants’ lamentable penchant for succumbing to irrational grief and despair at the first sign of trouble.

“Despite recent market turmoil, financial conditions remain near the easiest level in history,” Kostin wrote Friday afternoon, as US equities were busy careening lower in another late-day swoon. Goldman’s US Financial Conditions Index, he noted, sits at 97.5, some 120bps looser versus levels seen just prior to the pandemic (figure on the left, below).

You’ll immediately note (from the visual) that there simply is no precedent for the current state of affairs. Even with 2022’s nascent tightening tantrum, the read-through from short- and long-term rates, credit spreads, exchange rates, and equity prices, is that conditions have never been more accommodative.

That’s another way of expressing the sentiments conveyed in “An Air Of Panic.” The Fed is still easing. They’re still buying bonds. And rates are still glued to the lower bound. Merely discussing a move away from extreme accommodation is now enough to cause indigestion across markets.

Notably, the rally in equities accounted for the vast majority of the loosening in financial conditions since 2020. You can see that in the disparity between the dark blue line and the light blue line in the figure (above). “Equities accounted for more than 80% of US FCI easing since the onset of the pandemic,” Goldman’s Kostin remarked. That, he wrote, is “double the 40% of FCI variation typically attributable to equities.”

For reference, the table (above, on the right) shows the change necessary in the variables which comprise Goldman’s index to bring about a 100bps tightening impulse. It would take a proper bear market in the S&P, for example.

The problem (and this is implicit in everything said above) is that it’s never “ceteris paribus.” All of this is inextricably linked such that, for example, a steep selloff in equities would almost invariably beget wider credit spreads. And, in an environment where bonds are increasingly likely to serve as a source of volatility and a drag on performance as opposed to a negatively-correlated offset for stock declines, sharp increases in yields are likely to prompt declines in stocks, in true “diversification desperation” fashion.

The point, though, is simply that financial conditions remain the easiest in history — for now, anyway. This year’s rate hikes may not change that. Or at least not in isolation.

Goldman’s work shows that “surprise” increases of 100bps in the fed funds rate can engender a sharp tightening in the FCI. But, as Kostin went on to say, the four hikes Goldman sees for 2022 are mostly priced in by rates traders, “suggesting this year’s hikes will have a more modest impact.”

Ceteris paribus, and such.