Monetary policy works on a lag, but over and over again in 2022, the Fed has emphasized the extent to which hawkish rhetoric, and the market’s reaction to that rhetoric, is already working to tighten financial conditions.
In the pandemic era, the majority of the FCI easing impulse, as measured by Goldman’s financial conditions index, came from the equities component. That’s why many analysts contend the Fed would be loath to countenance a rally back to record highs on US equity benchmarks — it would work at cross purposes with (desperate) efforts to tighten things up.
So far in 2022, the total 138bps of tightening in the bank’s index is split between the rise in 10-year yields and the decline in equities. The figure (below) shows the breakdown.
That 138bps of FCI tightening probably won’t cut it considering the sheer magnitude of the imbalances the Fed is trying to address.
“Due to the historically extreme current mismatch between the numbers of jobs and workers, our economists estimate the Fed will need to generate another 75bps of FCI tightening in order to slow wage growth to the pace of roughly 4% that would be consistent with the Fed’s overall inflation target of 2%,” Goldman’s David Kostin said.
The good news for stocks is that conditions can tighten via other avenues that don’t necessarily entail additional large losses for equities.
But that’s far too simplistic. Nothing happens in a vacuum, especially not multi-standard deviation bond selloffs, dollar appreciation and wider credit spreads. All of those things are conducive to concurrent equity weakness.
Beyond that, though, a crucial point (and I’ve mentioned this countless times previous), is that because stocks contributed the most to the FCI easing impulse, they should likewise carry the burden as conditions tighten. So far in 2022, bond yields have actually contributed a bit more.
“Based on the typical historical relationship, a 75bps FCI tightening would include a 9% fall in the S&P 500 to 4000 [but] equity bears point out that stocks have driven most of the FCI easing in recent years and argue that equities should therefore account for most of the tightening going forward,” Kostin went on to write, noting that even after 138bps of tightening, the bank’s US FCI still ranks in just the 6th%ile going back more than 30 years (figure below).
When you strip out the equity component, the FCI ranks in the 59th%ile.
If stocks were to account for the entirety of the remaining 75bps of FCI tightening Goldman’s economists believe is necessary to help the Fed cool the economy, the S&P 500 would need to fall another 15% to 3700, Kostin said.
He did note that history is replete with instances of financial conditions tightening alongside a rally in stocks. “Recent Fed hiking cycles (1999, 2005-2006 and early 2018) represent periods when equities continued to climb despite overall FCI tightening,” Kostin wrote.
The problem, he went on to say, is that “each of these episodes eventually resulted in sharp equity downturns.”
Bear markets in equities are un American…