Tighter financial conditions are sounding the alarm for the global economy

Financial conditions is a general term for how parameters such as exchange rates, capital fluctuations, and borrowing costs affect the availability of funds in an economy.

The degree of weakening or tightening of conditions determines the plans for expenditures, savings and investments of enterprises and households.

Goldman Sachs, which compiles the most widely used indexes of financial conditions, has shown in the past that a 100 basis point tightening reduces growth by one percentage point in the coming year, and equivalent easing provides a corresponding boost.

This tightening is an unwelcome development for the global economy, which is already threatened by a drop in oil prices to $120 a barrel and supply chain disruptions caused by sanctions against Russia.

(Graphic: GS Global Financial Conditions, https://fingfx.thomsonreuters.com/gfx/mkt/lgpdwaqwwvo/KNQdg-global-financial-conditions-tighten-to-pandemic-levels.png)

If these factors push inflation higher and “if central banks take their mandate seriously, you will see further (tightening) financial conditions,” said René Albrecht, a strategist at DZ Bank.

“The economic momentum will slow down further, inflation will still be high and you will see second order effects, then you will have a stagflation scenario,” he added, referring to a combination of higher inflation and slower economic growth.

The Goldman Sachs Global Financial Conditions Index (GCI) was 100.2, 60 basis points (bp) lower than before the Russian invasion of Ukraine and a level that was not reached in March 2020 when the pandemic began to rage .

The rise was driven by the Russian ICF, which reached 114.8 from about 98 in early February to its lowest level since the 2008 crisis caused by a doubling of interest rates and a market crash.

The Russian move has driven emerging markets ICF to its lowest level since 2016.

(Graphic: GS Russia Financial Conditions, https://fingfx.thomsonreuters.com/gfx/mkt/dwpkrlqrevm/aWMrB-russian-financial-conditions-tighten-to-gfc-levels-nbsp-.png)

Movements in the euro area are also important. Conditions in the bloc, which is heavily dependent on Russian energy, are the tightest since November 2020, having moved 50 basis points in February, thanks in part to the European Central Bank (ECB) that began raising interest rates this year.

Viraj Patel, global macro strategist at Vanda Research, said financial conditions will become even more important for the ECB, which meets on Thursday.

If it cancels its bond purchases and subsequent rate hikes, as planned before the invasion, financial conditions could tighten to levels seen at the height of the pandemic or even the bloc’s sovereign debt crisis a decade ago, he added.

In the US, conditions have tightened to a lesser extent.

But the indicators Goldman uses to calculate its indexes don’t signal relief; safe-haven flows are boosting the US dollar, which is at nearly a two-year high, and global equities are down 11% this year, driven by a nearly 20% drop in eurozone equities.

Risk premiums on investment-grade US corporate bonds are up 40 basis points year-to-date as investors weigh the impact on corporate earnings.

Given that conditions in developed markets have historically been volatile, policy makers may not be too upset yet. Adjusted for inflation, the cost of borrowing fell sharply, hitting a record -2.5% in Germany on Monday.

Peter Chatwell, head of multi-asset strategy at Mizuho, ​​said it gives central banks “more leeway to speak hawkish and those who are going to act hawkish.”

(Chart: Eurozone GS Financial Conditions, https://fingfx.thomsonreuters.com/gfx/mkt/zdvxokjogpx/xoJke-euro-are-financial-conditions-at-tightest-since-late-2020-nbsp-.png)

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