FCI -- an index you definitely need to keep an eye on ..... yes, another one.

FCI  --  an index you definitely need to keep an eye on ..... yes, another one.

ref :- "The Market Is Acting Like the Fed Cut Rates" , Bloomberg Markets

Imagine that oft-quoted visitor from Mars had landed just as the Fed were hiking rates by 25 basis points on Wednesday night. Having no context in which to judge the move he or she might have assumed that it would provoke an upward reaction in the dollar and bond yields, and the opposite in stocks and bond prices  --  fortunately these space-travelling extraterrestrials are always equipped with some basic economic theory.

In reality of course the rate increase had the opposite effects, and it's simple enough to explain why. By the time the Fed's decision was announced, a hike was fully expected and already priced into markets. The only way that we might have seen the kind of action the Martian would have expected was if the move had been accompanied by further hawkish noises from Chairwoman Janet Yellen, and/or a noticeable steepening of "dot-plot" projections from Fed members for the upward course for interest rates.

As we suspected, neither the noises nor the steepening were forthcoming and with the hike fully discounted into prices, the "Buy on rumour / Sell on fact" principle applied. As we say, simple enough ..... except these moves point to something deeper going on, something that the Fed may have to get a firm grip on in the near future, according to Bloomberg.

Many banks and government agencies calculate and publish Financial Conditions Indices (FCIs) ..... the tightness or looseness of monetary conditions is a function of more than just the rate of interest on overnight money imposed by the central bank (in other words, Fed Funds in this case). Individual indices may vary slightly in their weightings and make-up, but essentially the five factors that go toward the calculation of an FCI are :

1. The yield on longer-term US Treasury bonds

2. The Fed Funds rate

3. The trade-weighted value of the US dollar

4. The value of equities, as measured by the S&P 500 index for example

5. Investment Grade Credit Spreads  --  the difference in yield between a US Treasury bond and a corporate bond of investment quality

According to the FCI's published by both Morgan Stanley and Goldman Sachs, by the end of Wednesday financial conditions has actually EASED by 14 basis points. The Fed Funds rate may have been increased (entirely as expected), but the lower bond yields and weaker dollar contributed to an easing in FCIs. Importantly, so too did a further jump in equity prices, due to the increased wealth implied by higher asset prices. In fact, despite two rate hikes in the interim , FCIs are showing that that falling credit spreads, the S&P's bull run and the failure of the dollar to carry through with its immediate post-election rally mean that the measures of financial conditions are actually easier than they were in early December.

It's not the first time that similar developments have caused problems. Back in 2005, former Fed Chairman Alan Greenspan was frustrated by the effectiveness of repeated interest rate hikes being undermined by falling long-term bond yields and rallying equity markets. At that time, the blame was laid at the door of a global glut in savings.

12 years later, the stimulus provided by easier financial conditions could become a big problem for the Fed at a time when they are trying to tighten things up. They're not unaware of it  --  Ms Yellen did talk about how higher stock prices were boosting consumer spending, and referred to how the falling premiums required for debt issued by low-rate companies reflected an easing in financial conditions, "a factor that affects the outlook" for the economy and for rates, she concluded.

New York Fed boss William Dudley was more direct : "If financial conditions were not to tighten at all or only very little, then ..... we would likely have to move more quickly".

Now it should be said that not everyone believes FCI's to be a reliable tool to base policy on, but given their own evaluation of the looseness of current conditions and the momemtum in the US economy, it's not surprising that Goldman have turned a bit more hawkish in their view on Fed policy ...... next hike in September, for example. Perhaps more interestingly, on the subject of reducing the Fed's balance sheet (which would by definition lead to tightening), they think that the Fed will announce an end to the practice of reinvesting the principle payments received when their bond holdings mature sometime in the 4th quarter, more than 6 months earlier than their previous prognosis.

As Morgan Stanley put it, you raise rates to tighten financial conditions ..... and if that doesn't work, "there's more work to be done".