Why are financial conditions so benign?

  • Financial conditions have eased to the same levels as 2007
  • This comes in spite of central banks thinking they are running restrictive policy
  • The nature and timing of the market moves suggest these not so much reflect or anticipate the strength of the economy as drive it
  • Their ultimate cause is easy balance sheet policy having crowded investors into risk
  • Misunderstanding of these dynamics increases the likelihood of bubbles and subsequent busts

Investors - and even some central banks - are increasingly conscious of the evidence of potential froth in financial markets. But there is very little consensus as to how much of a problem this is, and still less regarding what to do about it.

The most widely held view is that much of the risk rally simply reflects upside surprises in the real economy, and as such is nothing to worry about.

But a closer analysis of risk assets and volatility demonstrates that markets are not so much anticipating economic strength as driving it - and that they in turn have been disproportionately driven by easy central bank balance sheet policy. This presentation, prepared originally for the ECB, shows how this has undermined the impact of higher rates, and crowded investors into risk assets.

With many investor positioning metrics not yet at extremes and the Fed on the verge of slowing QT, it seems quite likely that - beyond a few seasonal factors - conditions become more extreme still. But better understanding of these dynamics should help investors outperform - and stop central banks from fuelling first bubbles and then busts.

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