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Can You Believe Financial Conditions Have Yet to Tighten?

CAMS Weekly View from the Corner – Week ending 7/21/2023

July 24, 2023

Chairman Powell of the Federal Reserve has occasionally addressed the topic of general financial conditions and how they have tightened in the recent interest rate raising campaign by him and his colleagues.

This has not gotten a lot of attention but at times when he does address the topic it has left many confused as to what he is seeing to suggest this is actually occurring.

To be clear tightening general financial conditions goes beyond seeing mortgage rates move higher for example. Collective market participants play a role in this as well as others in the broad financial system. The Fed is the kingpin in the mix though as they as a sole entity have much power in steering said conditions.

We addressed this topic in the latter fall season of 2022 as general financial conditions began trending down just as Chairman Powell was stating how they had tightened considerably over the previous year during a post interest rate setting meeting Q&A session.

The dichotomy left us and many confused. Since then the topic has been addressed sparingly all while these conditions have continued to loosen.

Above is a National Financial Condition Index produced by the Chicago branch of the Federal Reserve System.  The chart dates back to 1970 for a broad perspective.  In this Index the zero line (flat horizontal black line) denotes whether general conditions are tight or loose. 

After a rocket ride upward in 2021 with a simultaneous recession we have seen this index remain sub-zero all the way through to current day.

A brief look at the chart in whole offers how north of the zero line this index can and has gone in the history depicted. The light shaded blue vertical lines illustrate recessions so we can see how these general financial conditions, when moving notably higher, often bring recessions.

As offered, since October of 2022 this index has been softening to the point of putting in a downtrend. As an aside, this may be why the old adage “Don’t Fight the Fed,” which is well known among collective market participants, has not been acted upon by participants, in particular since October.

This adage offers when the Fed is tightening financial conditions don’t try to fight them in your market(s) participation. This may not be occurring because conditions have not tightened as they have in history. The “Don’t Fight the Fed” mantra certainly appeared in 2022 but since October of 2022 financial conditions have loosened and with this so have markets.

Above is the same Chicago Fed Index but this version narrows the timeline to the previous ten years so we can more clearly see what has occurred in recent time.

Our first red arrow depicts the uptrend in general financial conditions which means conditions were tightening. In this time period markets were experiencing a rough period.

Our second red arrow depicts the downtrend that we have been experiencing since October of 2022 and with this market’s have loosened considerably.

Importantly, underlining that we have a downtrend in place, note how our small red horizontal line has been taken out to the downside by the index line. In trend analysis when a lower low is put in we have confirmation that a downtrend is in play.

As markets have brightened in the last several months, leaving many confused as to how this can be with the well established “Don’t Fight the Fed” mantra, the above offers there has been no Fed to fight if you will when looking at broad financial conditions.

THE Question

In recent editions we have addressed the on-going dominant narrative and how it has taken on a life of its own. Getting right to the gist of it basically it goes price inflation is dead and the economy will not only not have a soft landing but there will be no landing at all as in the economy pushes along its merry way. Price inflation dead/economy excellent – got economic perfection?

Through history we have not seen an experience where a historic run of price inflation encompassed society and then went away as though it never happened all while general financial conditions never truly tightened (through the lens of history) and yet price inflation disappeared and no recession ever entered the economic landscape.

The question is will this time be different?

Long time market participants know the “This Time is Different” phrase is death knell type language when it is used relative to a significant macro storyline to the point that even hearing it often makes many run in the opposite direction. True kryptonite to markets’ superman.

Nonetheless, per the aforementioned narrative in conjunction with the history shared above for general financial conditions, this time will be different, like extremely different as in way different if the on-going narrative is to be proven correct.

Historically, generational type readings on price inflation for many continuous months that pushes into years does not vanish without economic pain depicted by serious tightened financial conditions and recession. This time may be different but most likely not using history as our guide. Bottom line – keep an open mind in either direction.

Interestingly, there are some areas of the financial system that are beginning to tighten their belts which if continues could lean into the above Chicago Index displaying a different trend than it is currently. We will monitor and share in near-term editions as they unfold.

I wish you well…

Ken Reinhart

Director, Market Research & Portfolio Analysis

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