MNI: Little Sign of Financial Stress In Fed Index

--Current Loose Fin'l Conditions Driven By Low Volatility, Narrow Spreads

--Chicago Fed Leverage Measure Linked to Imbalances Closer to Historical Average

By Jean Yung

     WASHINGTON (MNI) - Low interest rates, record-setting stock prices and

narrow credit spreads making for the most accommodative U.S. financial

conditions in decades have analysts worrying about excess, but a barometer out

of the Federal Reserve Bank of Chicago traditionally associated with financial

imbalances has remained subdued.

     A subcomponent of the Chicago Fed's National Financial Conditions Index,

the nonfinancial leverage subindex, currently gives little indication of

financial stress. 

     Tight financial conditions are associated with below-average credit and

leverage, the latter of which provides a reference point for financial debt

relative to equity. The nonfinancial leverage subindex is a highly predictive

and robust leading indicator of financial stress, able to signal imbalances up

to a year ahead.  

     It nosedived in the aftermath of the financial crisis. After bottoming out

in 2011, it has risen steadily toward its long-run average of zero, registering

at -0.23 in the week ended Jan. 5.

     Overall, the National Financial Conditions Index, an important gauge of

financial activity tracked by policymakers, "is currently close to but slightly

below its mid-2014 value," according to Chicago Fed economist Scott Brave, who

oversees development of the index.

     The weekly indicator is constructed as a weighted average of 105 indicators

of risk, credit, and leverage in the U.S. financial system and is

methodologically similar to other financial condition measures such as the

Goldman Sachs financial conditions index. Positive values indicate financial

conditions that are tighter than on average, while negative values indicate

financial conditions that are looser. 

     The last time the index was lower was in the late '90s. An adjusted version

of the index that takes into account current levels of economic growth and

inflation is seeing a similar trend and currently sits close to the range last

seen in the middle of 2015. 

     Late 2016 seems to mark an inflection point for the index, as the driving

factors behind loosening conditions began to intensify, according to the index.

That roughly coincides with Donald Trump's surprise election win, which gave way

to a historic market run-up on anticipation that a one-party sweep of Congress

and the White House will deliver fiscal stimulus, tax cuts and regulatory relief

to businesses. 

     Since then, both the unadjusted and adjusted National Financial Conditions

indexes have dipped about two-tenths standard deviations from their historical

means, to -0.91 and -0.76, respectively, in the week ending Jan. 5. 

     "What's been driving that has been pretty consistent across the unadjusted

and adjusted versions: low volatility in equity and treasury markets and

compressed interest rate spreads," outweighing factors such as high yield bond

spreads and consumer credit spreads pushing in the opposite direction, Brave

said.  

     Risk premiums, price volatility and parties' willingness to borrow and lend

at prevailing prices are largely driving the easy financial conditions, "as

opposed to the leverage category," Brave said. He declined to comment directly

on what trends in the index might imply about the outlook for the economy, the

transmission of monetary policy or financial stability. 

--MNI Washington Bureau; tel: +1 202-371-2121; email: kevin.kastner@marketnews.com

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