Goldman: All Those Strange Things Happening in Markets Could Help Keep Interest Rates Low

New banking rules introduced in the aftermath of the financial crisis are contributing to a tightening of financial conditions.

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Ingredients for the Goldman Sachs Financial Conditions Index: Take a liberal heaping of 10-year U.S. Treasury yields (36.5 percent), a generous portion of BBB-rated nonfinancial credit spreads (29.7 percent), a dollop of the credit risk indicator known as the TED spread (15.8 percent), a bit of the price-earnings ratio on the S&P 500 (4.7 percent), a dash of the Goldman Sachs broad trade-weighted dollar index (7.9 percent), and a sprinkle of the federal funds rate (5.5 percent).

Mix it all together and you should get something that looks like this:

GSfinconditions
Source: Bloomberg

With ingredients so closely tied to funding costs in all-important markets such as the vast and shadowy repo market, it should be no surprise that all those weird occurrences in fixed-income and credit markets have been feeding through to the GSFCI, helping to tighten financial conditions ahead of the Federal Reserve's all-important policy meeting this month. Those occurrences include so-called swap rates trading below equivalent U.S. Treasury yields—a rare situation that has been blamed on regulation and unwillingness to engage in risky arbitrage trades ahead of the all-important yearend.

On that note, Alec Phillips at Goldman Sachs made the case over the weekend that the deluge of post-financial crisis regulation is helping to tighten the GSFCI. Among them are the Basel III capital requirements and the Volcker Rule, which are said to have shrunk banks' willingness to hold and trade corporate debt on their balance sheets, arguably reducing liquidity and risk appetite in the credit market. Meanwhile, leverage ratios and other funding reforms have limited general bank balance sheets and helped prevent a host of other financial market players from trading in the market.

On net, we expect that regulatory-related balance sheet pressures have incrementally tightened the GSFCI over the last year, all other things equal. Given that much of the impact of these changes is due to the interaction of the rules, tracking their effect by timing is difficult, particularly as banks are likely to adjust to new rules well ahead of their actual implementation. Nevertheless, the effect seems to have been somewhat more pronounced recently—the shift in swap spreads is the most notable example—and seems likely to become larger as additional changes phase in. For example, the upcoming stress test will incorporate the supplementary leverage ratio for the first time (the ratio is already being disclosed but does not become binding until 2018). Monthly liquidity measurement will also shift to daily in July 2016, suggesting that some of the balance sheet constraints most apparent at month-end could become more frequent. Other rules have yet to be finalized, like the Net Stable Funding Ratio, the details of which are likely to have additional implications for the pricing of repo. The effect on financial conditions is also likely to ultimately be greater as reduced liquidity raises the risk of greater dislocations if markets come under stress.

While one could easily argue that fragile markets and the possibility of heightened volatility is exactly the kind of thing that should worry investors as we inch toward the Fed's potential first interest rate hike in almost a decade, the Goldman analyst opts to go the other way (sort of). He argues that the U.S. central bank will likely offset any overshoot in financial condition tightening with looser monetary policy, which should help keep interest rates low and help boost economic growth.

How such a tightening in financial conditions impacts growth depends on the monetary policy response. While a tightening would be associated with a reduction in growth, we would expect monetary policy to respond to a tightening in financial conditions, just as the Fed has been shown to use monetary policy to offset changes in fiscal policy. As New York Fed President Dudley explained in a speech last year, “We will pursue the monetary policy stance that best generates the set of financial market conditions most consistent with achievement of the FOMC’s dual mandate objectives. This depends both on how financial market conditions respond to the Fed’s policy actions and on how the real economy responds to the changes in financial conditions.” The upshot is that a structural tightening in financial conditions resulting from regulation could result in a slightly lower equilibrium real fed funds rate (r*). This is one potential reason why we expect r* to ultimately settle in the 1 percent to 2 percent range, moderately below the historical norm.

One to watch.

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