You may be familiar with the Fed's recent statements on monetary policy, whether from post-meeting press conferences or other events he attended. Fed Chairman Powell has been very cautious in his remarks.

He has repeatedly emphasized key points, such as inflation being below 2%, the need for a long-term restrictive monetary policy, no schedule yet for rate cuts, and the possibility of raising interest rates.

Initially, the market reacted strongly to the Fed's hawkish stance, leading to significant short-term volatility in the stock and bond markets. However, since the release of the November 21st meeting minutes, the market has become less sensitive, with CME predicting little change in December interest rate hikes. Many Institutions also maintain their view that the "interest rate cycle has already ended."

Powell's repeated mention of significant tightening of financial conditions is worth noting, especially his statement that the recent rise in long-term bond yields is an important driver of tightening.

So, how tight have financial conditions become? And how long will the financial market lag be? Today, let's explore the current situation of the US financial market.

Why is it said that financial conditions have tightened?

Here's an introduction to one of Wall Street's most closely watched indices: Goldman Sachs' Financial Conditions Index.

This index takes into account five variables: the nominal federal funds rate, 10-year Treasury yields, credit spreads, stock performance, and the value of the US dollar against a basket of currencies.

These indicators are usually highly correlated with credit and liquidity. For example, the federal funds rate is known as the "interest rate hike or cut," and a higher rate indicates greater financial tightening. The 10-year Treasury yield is a benchmark for mortgage loans, and higher interest rates will increase borrowing costs for consumers and businesses, indicating financial tightening. Credit spreads reflect the yield differential between bonds with different ratings, and tightening financial conditions often lead to an increase in credit risk, which widens credit spreads.

Therefore, essentially, changes between these components represent either financial tightening or easing. An increase in the index means that financial conditions are becoming tighter, and a steepening line means that tightening is happening faster in the short term.

As the date of October 18th, the index is slightly above 100, only slightly higher than the historical average level, indicating that financial conditions don't appear to be tight. However, if we track the trend, we can see that the US financial conditions have rapidly and substantially tightened over the past two years.

What happens when financial conditions continue to tighten?

Let's consider a scenario where homebuyers are unable to afford homes due to high interest rates, which decreases their purchasing power. Consumer spending is a fundamental driver of economic growth, so when consumption is suppressed, it can also possibly suppress the economy.

This is why the market is concerned that continued financial tightening may impact the economy's "soft landing" in the future.

Torsten Slok, Chief Economist at Apollo Global Management, warned against underestimating the impact of rising borrowing costs. Interest rate hikes and financial tightening will increase default rates for consumers and businesses and put downward pressure on loan growth.

Analysts have given grim projections regarding how long it takes for financial tightening to transmit to the economy.

Goldman Sachs economist Joseph Briggs explained that one percentage point of tightening means a one percentage point slowdown in economic growth next year. Most of the impact on the US economy can be felt in the first two quarters after the index begins to tighten.

J.P. Morgan strategists estimate that it takes one to two years for the impact of financial tightening to manifest itself on GDP. The full effect of the tightening policy in 2022-2023 may not be apparent in the real economy until next year.

Will there be more interest rate hikes? When will rate cuts be put on the agenda?

Many market participants believe that the Fed's current interest rate hike cycle is over. The focus has shifted to how long interest rates should remain high, rather than how high they should be.

The reason for holding off on raising interest rates is the recent tightening of financial conditions after a surge in long-term interest rates. This appears to have given the Fed room to adopt a less aggressive stance on interest rate issues.

The Fed's October statement warned that tight financial and credit conditions "may affect economic activity, employment, and inflation."

As the historic interest rate hike cycle may be coming to an end, financial conditions are at their most tense point in a year. The impact of the previous 525 basis points of interest rate hikes is evident in the rise in US Treasury yields that have reached new highs since 2006-2007, and the corresponding rise in yields is linked to stock markets, where the NASDAQ index fell by about 10% within the third quarter.

Economic data such as inflation, labor markets, and durable goods orders have also exceeded expectations, sending out cooling signals.

Despite the economic slowdown, the Fed continues to emphasize that interest rates may remain high for a long time and that there is little consideration of lowering interest rates.

However, the market believes that the first rate cut will begin in May next year. According to the CME FedWatch tool, as of November 23rd, they estimated a 44.9% probability of a rate cut in May 2024.

Some central banks in South America, including Brazil and Peru, have already cut interest rates. It is worth noting that the Brazilian and Mexican central banks started hiking interest rates earlier than the Fed, and they are now leading the way in cutting interest rates.

According to Jim Reid from Deutsche Bank, as of the end of November, the number of central banks cutting interest rates has surpassed those hiking interest rates for the first time since January 2021, which is a hopeful start for investors looking for a "soft landing" for the global economy.

Traders in the fed funds futures market are indicating virtually no probability that policymakers will increase rates again this cycle, and in fact are pricing in cuts starting in May. Ultimately, the market expects that the Fed will enact the equivalent of four quarter percentage point cuts before the end of 2024.

Ultimately, the Federal Reserve may continue to use its expertise in managing market expectations by influencing market trends through statements rather than taking substantive measures. However, with interest rate cuts, there may also be a slowdown in economic growth, and investors must be mindful of the risks that come with it.

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