29 Jan Understanding What “Tighter Financial Conditions” Really Means
For the last 18 months “tighter financial conditions” has been a recurring theme for just about every major financial news outlet. While the phrase is often used it rarely is defined by these “experts”. And rarely do they ever try and attempt to explain the nuances of how it is changing.
Part of the reason few attempt to define what “tighter financial conditions” means is that it is a challenge to acquire empirical evidence on just what is happening in the economy. Specifically, information regarding how difficult it is to obtain financing. The reality is capital comes through many channels: consumers take loans from banks, corporations (and governments) can issue bonds and in some cases equity that all are obscured by market factors in some critical way. While these options rarely run completely dry their costs and availability can vary greatly over time. Words such as strict, tight or rising rates all indicate that an environment where raising capital is more difficult.
Even the various Federal Reserve banks do not entirely agree on how to measure these tightening conditions. The Kansas City Fed uses just 11 indicators while the Chicago Fed’s model uses more than 100. Regardless of the number these models typically include the following major inputs:
- Credit Spreads: Yields of risky assets (corporate bonds) are compared to those with very little risk (US government debt). The difference, the spread, tells market observers how much an investor must be compensated to take on risk. The higher this difference goes the more hesitant an investor is in the long-term viability of the economy, business or individual.
- Volatility: Jumps in market volatility, like we have seen over the past two months, are signs of uncertainty. When uncertainty is around investors typically will take money out of the market to protect principal. This risk-off approach makes raising capital more expensive for those looking for it.
- Bank Performance: The Federal Reserve makes it a point to survey leading lending officials to see if they are loosening or tightening their loan requirements. Changes to underwriting standards give an indication on the direction of the economy.
- Equity Prices: The wealth effect kicks in as asset prices rise and investors feel wealthier. When investors have more wealth they are more likely to take on risk and lend their capital to others creating a less restrictive capital environment.
- U.S. Dollar Value: When the dollar increases relative to other currencies it is usually a product of higher interest rates in the US which equates to higher costs of borrowing.
So what is happening today? In every case listed above, we are currently in an environment where it is becoming more difficult/expensive to get capital for those looking to borrow. However, none of these metrics listed have risen to levels that would be considered restrictive. As we continue through 2019 keep an eye on these key items as they will help tell us whether or not we are on the edge of a slowdown in economic activity.