Tightening financial conditions are a warning sign for the global economy

Global financial conditions, which are thought to be strongly correlated with future growth, are at their tightest in two years, owing to rising energy prices, falling stock markets, and market fallout from the Ukraine-Russia conflict. The term “financial conditions” refers to how variables such as exchange rates, equity swings, and borrowing costs affect the availability of funding in the economy. The spending, saving, and investment plans of businesses and households are determined by how loose or tight conditions are.

Goldman Sachs, which compiles the most widely used financial conditions indexes, has previously shown that a 100-basis-point tightening reduces growth by one percentage point in the coming year, while an equivalent loosening boosts growth by the same amount. The tightening is an unwelcome development for a global economy already beleaguered by the fallout from $120-per-barrel oil prices and supply chain disruptions caused by Russian sanctions.

If these continue to drive inflation higher, and “if central banks take their mandates seriously,” “you will see a further (tightening) in financial conditions,” according to Rene Albrecht, strategist at DZ Bank. “Economic dynamics will slow down even more, inflation will remain high, and you will see second-round effects, and then you get a stagflation scenario,” he added, referring to a combination of rising inflation and slower economic growth.

Goldman Sachs’ global financial conditions index (FCI) is at 100.2, which is 60 basis points (bps) tighter than it was prior to Russia’s invasion of Ukraine and a level last seen in March 2020, when the pandemic first struck. The rise was led by its Russian FCI, which rose to 114.8 from around 98 at the start of February to the tightest since the 2008 crisis, owing to a doubling of interest rates and a market collapse. The Russian move has pushed the emerging market FCI to its tightest level since 2016.

The moves in the Eurozone are also significant. Conditions in the bloc, which is heavily reliant on Russian energy, are the tightest they have been since November 2020, having moved 50 basis points (bps) in February, aided by the European Central Bank (ECB) opening the door to rate hikes this year. According to Viraj Patel, global macro strategist at Vanda Research, financial conditions will become even more important for the ECB when it meets on Thursday.

If it proceeds with the expected unwinding of bond purchases followed by rate hikes, financial conditions could tighten to levels seen at the height of the pandemic or even the EU’s sovereign debt crisis a decade ago, he added. Conditions in the United States have tightened to a lesser extent. However, the indicators Goldman uses to calculate its indexes show no signs of improvement; safe-haven flows are boosting the US dollar, which is near two-year highs, and global stocks have fallen 11% this year, led by a near-20% drop in eurozone equities. As investors assess the impact on companies’ profits, risk premia on investment-grade corporate bonds in the United States have widened by 40 basis points year to date.

Because conditions in developed markets have historically been loose, policymakers may not be too concerned just yet. Borrowing costs have fallen sharply in inflation-adjusted terms, reaching a record low of -2.5 percent in Germany on Monday. According to Peter Chatwell, Mizuho’s head of multi-asset strategy, this gives central banks “more room to speak hawkishly and for those on the verge of acting hawkishly, acting hawkishly.”