Markets Confront Shocking Paradox

“Can a tightening be considered effective if financial conditions… ease?”

Claudio Borio, head of the Bank for International Settlements’ Monetary and Economic Department, here poses a thumping question.

The Federal Reserve bumped interest rates 0.25% one week ago today — its seventh rate hike since 2015.

The Fed is also hard at the business of quantitative tightening.

It has unloaded $112 billion of maturing bonds since it began last October.

Over half that $112 billion rolled off since the end of March alone.

And yet — and yet — we are reliably informed that U.S. financial conditions are presently the easiest since June 2014.

The Chicago outpost of the Federal Reserve operates a gadget called the National Financial Conditions Index.

This index, says the Fed:

Summarizes different financial indicators and, because [it] measures financial stress, can serve as a barometer of the health of financial markets.

The index features three components that track U.S. financial conditions on a weekly basis:

  1. Risk Subindex. This looks at volatility and funding risk in the financial sector.
  1. Credit Subindex. This looks at measures of credit conditions.
  1. Leverage Subindex. This looks at debt.

Any reading of zero or above is a warning of approaching weather.

Bear markets commenced in 1973, 2000 and 2007 when the index rose above zero, for example.

Recessions leading to major stock market corrections have also begun when the index topped zero.

When the index is below zero — on the other hand — it indicates easy waters are ahead.

What is the index’s latest reading?

Negative 0.81.

That figure, again, is the lowest reading since June 2014… when quantitative easing was still a going thing.

For your disbelieving eyes, evidence:

Chicago Fed Adjusted National Financial Conditions Index

What are we to conclude from today’s unlikely reading?

Analyst Troy Bombardia:

The National Financial Conditions Index (NFCI) and its components demonstrate that financial conditions are still too easy in the U.S. for a recession and bear market to start. Financial conditions need to tighten significantly before this equities bull market can end.

Just so. And reassuring if true.

But not every index tracking financial conditions employs the same metrics.

Perhaps, therefore, this NFCI gives a false reading of financial ease.

Let us instead look to Bloomberg’s own financial conditions index — maybe it draws a darker sketch.

Here, a chart comparing Bloomberg’s reading with the Chicago Fed’s:

Financial conditions remain easy amid the market volatility

Is it an exact fit?

No, it is not an exact fit — but let us not pick nits.

Both indexes reveal easy financial conditions.

“On balance,” confirms Bank of America Merrill Lynch, “financial conditions remain easy.”


Financial markets have taken both Fed tightening and geopolitical risks in stride. Concerns around Italy, trade, Iran and North Korea have caused brief, limited shocks to equity markets and have had little apparent impact on confidence.

Adds financial writer David Scutt:

Right now, and regardless of the measure, they’re all saying the same thing: There are few signs of stress, a somewhat remarkable outcome given some of the geopolitical headlines seen in recent months.

Meantime, our agents inform us that banks are beginning to relax their lending standards — despite rising interest rates.

Tighter money… easier financial conditions.

What does our central bank make of the paradox?

Mona Mahajan, strategist with Allianz, has said the paradox is “puzzling to the Fed.”

Doubtless true.

But what, may we ask, isn’t puzzling to the Fed nowadays?

We begin to suspect one plus one might overmatch it… the square root of four might stump it… the number of angles in a triangle might send it to the textbook.

Nine baffled years and trillions of confused dollars after the financial crisis, the Federal Reserve can’t even work a consistent 2% inflation rate.

Its beloved Phillips curve — the supposed tradeoff between unemployment and inflation — has been reduced to a sad joke.

And when was the last time anyone called the Federal Reserve chairman “Maestro”?

We nonetheless return to the topic under discussion…

Despite Fed tightening, trade war panics, raw geopolitical nerves and all of hell’s angels… today’s financial conditions are as easy as a streetwalker’s virtue.

And we must conclude a stock market collapse is not on tap as long as conditions remain so relaxed.

But we cannot say how long this pleasant state will endure…

Despite today’s easy conditions, Jim Rickards believes Fed tightening will ultimately trigger the next crisis.

Then it’s back to lower rates… and more quantitative easing.

In which case we wonder…

If financial conditions are so easy while the Fed is raising rates and hacking its balance sheet…

What will they be when interest rates are back to zero and QE4 is in swing?


Brian Maher
Managing editor, The Daily Reckoning

The Daily Reckoning