Bi-Weekly Asset Allocation – The Financial Conditions Problem


Confluence Investment Management offers a variety of asset allocation products that are managed using top down or macro analysis. We publish asset allocation thoughts every two weeks, updating the report every other Monday, along with a podcast.

Among the financial pundit class, there has been a growing call for weaker financial conditions. What are the financial conditions? They include credit spreads, level of interest rates, level of stocks, level of market volatility, dollar exchange rate, etc. Weaker financial conditions mean that borrowing costs increase and the perceived risk of investing increases. By increasing the costs of investing and borrowing, market participants (households, businesses, etc.) will often be more cautious, and this practice will tend to slow the growth of the economy. Essentially, the argument is that with “hot” inflation, using weaker financial conditions to slow investment and consumption will eventually lead to lower inflation.

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However, managing financial conditions is not a simple process. Once financial conditions start to deteriorate, they can almost take on a “life of their own”. In a sense, financial panics are evidence of rapidly deteriorating financial conditions. A modest weakening in financial conditions could reduce market “scum” and mitigate risk. Nevertheless, it may be difficult to contain a deterioration in financial conditions. Although there are several indices of financial conditions, we prefer the one generated by the Chicago Federal Reserve Bank. This index has 105 variables, including various interest rate spreads, volatility measures and the levels of several indices and interest rates. The index is updated weekly. A rising index suggests increased financial stress (worsening financial conditions). From 1973, when the index was launched, until mid-1998, there was a close correlation between the level of federal funds and financial conditions. For the most part, policymakers could use financial conditions as a “force multiplier” to improve policy. When the policy rate increased, financial conditions deteriorated at the same time. When politics eased, they quickly relaxed.

But, after mid-1998, the two data sets became nearly uncorrelated. What happened? Two factors likely affected this relationship. The first was the passage of the Gramm-Leach-Bliley Act, which eliminated the difference between commercial banking and investment banking. This bill changed the financial system, resulting in more financial activity outside the traditional banking system. In other words, the non-banking banking system has been favored by this bill. Why is this important? For example, instead of borrowing from a bank, companies could issue debt securities or make secured loans in a much less regulated environment. The increase in the policy rate did not necessarily lead to a reduction in borrowing, as financial markets have more means to provide liquidity due to regulatory changes.

The second factor has been greater transparency in monetary policy. Even in the late 1980s, the FOMC acted in secret. “Fed watchers” tried to guess whether a policy change had occurred by watching money supply data or changes in bank reserves. But in the mid-1990s, the FOMC began announcing the policy rate change, and over the years it has been increasingly transparent about its policy expectations. In general, society tends to regard transparency as a good in itself. But by clarifying the orientation of its policy, the markets could adapt and therefore had little to fear from “surprises”. In the non-banking banking system, participants could use derivatives to protect their positions from policy changes, making them less efficient.

Thus, due to changes in financial markets and increased openness, the FOMC has lost its ability to use financial conditions as an effective policy tool. For example, in the chart above, the FOMC steadily raised rates from 2004 to 2006. During that time, financial conditions remained unchanged. Then, in 2007-2008, when financial conditions deteriorated rapidly, aggressive rate cuts could do little to improve them. It took years of “zero interest rate policy” and cycles of quantitative easing (QE) to finally improve financial conditions to a level consistent with the period before the Great Financial Crisis.

Recent history shows that when financial conditions weaken, the FOMC takes aggressive and quick action to reduce them. In March 2020, financial conditions deteriorated quite rapidly, and not only did the FOMC lower rates quickly, but it implemented broad intervention in financial markets to support their function. Moreover, the balance sheet was expanded at a rate not seen outside of wartime. Obviously, the pandemic was part of the policy response, but widening credit spreads and other signs of financial stress were also part of the Fed’s actions.

While the call to deliberately undermine financial conditions is understandable, the chart above shows that it could trigger unintended results. We are no longer in a world where financial conditions deteriorate alongside changes in the policy rate. Instead, over the past 24 years, these conditions have shown a tendency to ignore policy tightening, only to deteriorate rapidly with little warning. A modest weakening in financial conditions could be welcome, increasing the potency of tighter policy. However, a sudden spike, as seen in 2008 and 2020, could be destabilizing, forcing the FOMC to quickly reverse its current policy course. Unfortunately, such events are almost impossible to predict in advance, although we can say that they seem to occur after cycles of tightening.

It is possible that 2008 and 2020 reflect the immaturity of the non-banking financial system and that markets have moved to a point where such market events have become less likely. The safety nets offered by the Fed in March 2020 could serve as a model for containing financial crises. Therefore, letting financial conditions deteriorate is less risky. However, it seems to us that the burden of proof is to prove that the crunch won’t “break something”. And so, we remain vigilant, watching for funding issues that could trigger a run on liquidity and force the FOMC to relax.

Past performance is not indicative of future results. The information provided in this report is for educational and illustrative purposes only and should not be construed as individualized investment advice or a recommendation. The investment or strategy discussed may not be suitable for all investors. Investors should make their own decisions based on their specific investment objectives and financial situation. The opinions expressed are current as of the date indicated and are subject to change.

This report was prepared by Confluence Investment Management LLC and reflects the current opinion of the authors. It is based on sources and data believed to be accurate and reliable. The opinions and forward-looking statements expressed are subject to change. This is not a solicitation or an offer to buy or sell securities.

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