Chart of the Week : Financial Condition Indexes

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With the Fed’s new monetary stance and the recent increase in market volatility, attention has turned to financial conditions. The below charts show three common gauges of broad financial conditions in the United States (the National Financial Condition Index, the Kansas City Financial Stress Index and the Office of Financial Research Financial Stress Index or OFR FSI). There is little methodological difference in the construction of these three indexes. The OFR FSI is updated on a daily basis while the two others are updated on a weekly basis. We tend to closely monitor the OFR FSI because it can track almost in real time a sudden increase in financial stress with major negative implications for financial assets, typically equities. The OFR FSI is now at minus 1.79 – a negative reading means that stress levels are below average. In comparison, it climbed to 10.26 at the start of the pandemic in March 2020. This was below the historical peak of 29.32 reached in October 2008 in the aftermath of the bankruptcy of Lehman Brothers. All of these indexes show current U.S. financial conditions are comparatively accommodative. There is still enough liquidity in the market, though it is decreasing. This partially explains the recent market turmoil. We know that the U.S. Federal Reserve will watch closely for any sign of financial stress resulting from the ongoing monetary regime change. This will certainly influence the pace of monetary policy normalization more than any major statistics (such as unemployment and even inflation data). The last time the OFR FSI turned positive (meaning that stress levels are above average), the Fed had no other choice than to stop its rate-hiking cycle and ultimately reverse it. It was in December 2018. If history is any guide, expect that the Fed will likely stop its hiking cycle which is about to start from March onwards when the OFR FSI will be close or in positive territory. It could happen sooner than most expect.