IMF staff has developed global financial conditions indices for 43 global economies. Conceptually, these indices extract the communal component of range of indicators for local financing conditions, independent of economic conditions. The idea looks like a good basic principle for building FCIs for macro trading strategies. The research on these indices suggests that [1] financial conditions are a warning sign for recessions, and [2] global financial shocks have a powerful impact on local conditions, particularly in the short run and in emerging economies.

IMF Global Financial Stability Report, April 2017,  Chapter 3, “Are Countries Losing Control of Domestic Financial Conditions?”

The post ties in with this site’s lecture on macro trends, particularly the part on using dynamic factor models for distilling information from a range of indicators, and with this site’s lecture on systemic risk in emerging markets.
The below are excerpts from the IMF Global Financial Stability Report. Emphasis and cursive text have been added. Formulas have been paraphrased verbally.

What are financial conditions indices

“Financial conditions broadly reflect how easy it is to obtain financing.”

“Empirically, financial conditions indices (FCIs) are unobservable, or latent, variables that are estimated using a wide range of financial variables so as to best reflect the financial conditions faced by domestic…firms and households…FCIs… aim to distill information from a broad array of financial variables—including measures of risk taking and various kinds of financial frictions— ideally capturing the prevalence of credit constraints and the magnitude of external financing premiums.”

How to measure financial conditions across countries

“[Previous research] has concentrated primarily on developing FCIs for the United States and, occasionally, for major economies of the Organisation for Economic Co-operation and Development…[Our research] develops new FCIs that are comparable across a large set of advanced and emerging market economies…focusing on measures of financial conditions that are purged of macroeconomic fundamentals… [Our research] estimates comparable monthly FCIs for 43 advanced and emerging market economies during 1990–2016, depending on data availability.”

“The financial conditions indices are estimated…at monthly frequency… using a set of 10 financial indicators…[based on a] time-varying parameter vector autoregression model and a dynamic factor model…The model takes the following form:
[1] the vector of financial indicators is related to the impact of a concurrent vector of macroeconomic variables and a concurrent latent factor representing the FCI.
[2] the joint vector of macroeconomic variables and FCI is related to its own past values.”

“Roughly speaking, the model decomposes the main patterns across a broad range of variables into a measure of financial conditions… and a business cycle component…This method jointly considers the dynamic interactions of the FCI and macroeconomic fundamentals, and has two notable advantages.

  • First, the method aims to purge the FCI of the effects of macroeconomic conditions. Although empirically difficult, conceptually this purging is desirable—ideally, the estimated FCIs would therefore entail primarily exogenous shifts in financial conditions that are distinct from the endogenous reflection of macroeconomic fundamentals.
  • Second, because the parameters are allowed to change, the model can account for the evolving relationships between macroeconomic and financial variables over time.”

N.B.: This approach may be quite ambitious and demanding in terms of data and assumptions. For the purpose of trading strategies it can be simplified.

Why financial conditions are important to watch

“The financial conditions indices…tend to signal downside risks to GDP. Domestic FCIs are significant predictors of future GDP growth across countries; however, this relationship changes depending on the state of the business cycle. In particular, the inverse relationship between FCIs and future GDP growth is stronger for economic contractions than for expansions…FCI measures appear to signal downside risks to GDP well.”

“If the mapping from policy rates to this range of financial variables is not unique or stable, then tracking financial conditions can be helpful in predicting the impact of monetary policy.”

The importance of global trends for local financial conditions

“Because financial conditions can spill across countries, it is important to distinguish between two different effects.

  • First, as countries become more integrated into the global economy, their financial conditions are more likely to be affected by external shocks
  • Second, global financial integration may weaken the transmission channels of monetary policy. For example, if longer-term bond yields are increasingly set in international markets, their responsiveness to short-term interest rates set by central banks may decline.”

A single factor, ‘global financial conditions,’ appears to account for a large share of variation in domestic financial conditions around the world. This factor moves in tandem with the U.S. FCI and measures of global risk…Various studies suggest that financial conditions around the world are heavily influenced by global factors…Many studies emphasize the important role of global ‘push factors,’ such as the VIX, as drivers of financial variables…On average, global financial conditions account for about 30 percent of the variation in financial conditions across countries, and though not shown, reaches almost 70 percent in several economies.”

“Given that local financial conditions react more rapidly to global financial shocks than to changes in domestic policy rates, timely policy responses may often be difficult. Emerging market economies, in particular, clearly need to guard against the risks associated with sharp changes in global financial conditions.”

“Financial linkages (such as cross-country investments) are the most reliable indicator of global financial conditions’ influence on local FCIs…

  • FCIs in countries with stronger financial linkages (proxied by foreign direct investment) with the United States tend to be more synchronized with global financial conditions…
  • Deeper financial (equity, bond) markets in particular, are associated with an attenuated impact of global financial shocks on domestic FCIs. This echoes the conclusions [other IMF analyses]…which find that a larger domestic investor base and deeper banking systems and capital markets can increase the resilience of emerging market economies to external financial shocks.”