Common measurements of financial conditions can give misleading results. We believe our new Financial Conditions Indicator (FCI) is a better gauge. Elga explains why.
U.S. financial conditions have tightened significantly since risk assets began to falter in the summer. Why does this matter for investors? Financial conditions describe how changes in financial asset prices impact economic growth. The more they tighten, the more they weigh on economic growth. The more they ease, the more they boost growth. But financial conditions are tough to measure.
Common gauges—which include interest rates, market volatility and asset valuations—can give misleading results. This is because unadjusted financial asset prices tend to both reflect growth news as well as drive growth news. Take the following example: Rising U.S. growth expectations can push up yields and the dollar. This could lead to the deceptive conclusion that financial conditions are tightening and the growth outlook is deteriorating. Most common gauges account for the impact of the business cycle thus far on financial asset prices, but they do not account for the fact that current economic expectations also affect today’s asset prices and hence financial conditions.
Financial Conditions Indicator (FCI)
Our latest Macro and market perspectives, A tale of tighter conditions, introduces our Financial Conditions Indicator (FCI)–a better gauge of financial conditions, we believe, than common measurements. Our new FCI seeks to avoid the problem of common gauges by fully stripping out the impact of growth news on asset prices from the underlying asset prices for government bonds, corporate credit, equity markets and the exchange rate. Once the forward-looking factor is also removed, our FCI behaves more closely in line with economic theory. Case in point: an increase in interest rates and yields following better growth news does not lead to an assessment by our metric that financial conditions have tightened.
Our FCI provides a measure of the impact that financial conditions are exerting on the growth outlook–as proxied by the BlackRock Growth GPS–and not the impact of the current growth outlook on financial conditions. Its inputs include policy rates, bond yields, corporate bond spreads, equity market valuations and exchange rates.
What is our new FCI telling us?
It shows financial conditions in the U.S. and in the euro-zone are tightening. Moves in our FCI have historically led our growth GPS by around six months. Tighter financial conditions suggest that growth in the U.S. will likely decelerate in the coming twelve months. See the Tighter times chart.
All other things equal, this implies slowing, but above-trend global growth in 2019, we believe. The sell-off in financial markets since the summer and ongoing Fed policy tightening would be consistent with U.S. gross domestic product (GDP) growth slowing to just under 2.5% next year from almost 3% now. The market sell-off since September has alone caused a tightening in financial conditions equivalent to a 35 basis point decline in the U.S. Growth GPS....MORE
What does our FCI say about monetary policy?....
