Is the easing real or an illusion?

At the last meeting of the US Federal Reserve (Fed) in December 2023, its Chair Jerome Powell gave a particularly accommodative speech, subsequently deemed to constitute the long-awaited pivot in the direction of monetary policy. The direct consequence of this speech was also an “easing in financial conditions,” as the jargon goes. Despite interest rates subsequently rising and inflation fears resurfacing, financial conditions have continued along this trajectory.

But what exactly do we mean by “financial conditions”? This is most often a reference to the various indices for financial conditions in markets. Whilst there are many of these, each with their own specifics, these indices all work in more or less the same way: they aggregate various market data, generally including the level or valuation of equity markets, risk premia in bond markets, the level of nominal interest rates and exchange rates. All of these indicators are then weighted, often based on their supposed impact on GDP momentum. This is because the concept of financial conditions in markets is based on the assumption that financial variables have a direct influence on economic activity. So a rise in equity markets – in particular in the US where a large proportion of savings are invested in markets – creates a positive wealth effect with a favourable knock-on effect for consumption and investment. An easing in credit risk premia facilitates financing for companies that are primarily funded via the markets.

Seen from this perspective, it is clear that the situation in recent months – characterised by a violent rally in equity markets, a compression of credit risk premia and a stabilisation of interest rates – corresponds to an easing in financial conditions in markets. However, it is important to distinguish between this notion – intricately linked to stock markets – and financial conditions in the real economy. On this front, any easing is far from obvious.

In the US, households remain under pressure. The 30-year mortgage interest rate – the reference for the real estate market – remains above 7%, and demand for loans is still extremely low. The average interest rate on credit cards is still well above 20%. Auto loan rejection rates are constantly rising. Companies that are not financed via the markets are hardly any better off. Based on the most recent survey of the National Federation of Independent Business among SMEs, the average interest rate paid on short-term loans is at a recent high of 9.8% – an unprecedented level since the start of the noughties. The situation is hardly better in the eurozone. In the most recent Bank Lending Survey of the European Central Bank (ECB), we can see a slight improvement for consumer credits, more significant for mortgages. On the corporate front meanwhile, the fall in demand for loans is accelerating, whilst lending terms are still tightening, albeit only marginally.

So as debate rages on Wall Street as to whether central banks have sufficiently tightened their monetary policy and whether financial conditions have eased too much, on Main Street the situation is unequivocal – financial conditions are and remain extremely restrictive.

Final version of 12 April 2024 – Enguerrand Artaz, Fund Manager, LFDE