There are two ways to use financial conditions indicators for macro trading. First, the tightening of aggregate financial conditions helps forecasting macroeconomic dynamics and policy responses. Second, financial vulnerability indicators, such as leverage and credit aggregates, help predicting the impact of an initial adverse shock to growth or financial markets on the subsequent macroeconomic and market dynamics. The latest IMF Global Financial Report has provided some clues as to how to combine these effects with existing economic-financial data.
The post ties in with SRSV’s lecture on macroeconomic trends,particularly the section on how to align macro indicators with trading positions.
The below are excerpts from the paper. Emphasis and cursive text have been added.
“This chapter refers to a combination of financial indicators, or an index constituted of them, as financial conditions. The term ‘financial conditions’ often refers to the ease of funding… One attractive option is a single financial conditions index (FCI).”
On the basic principles of building financial conditions indices across countries based on IMF research view previous post here.
“Over a horizon of one to four quarters, tighter financial conditions—as reflected in higher univariate FCIs—predict increased downside risks to GDP growth in most advanced economies and a more uncertain growth outlook in several emerging market economies.”
“A tightening of financial conditions, reflected in a decompression in spreads or an increase in asset price volatility, is a significant predictor of large macroeconomic downturns within a one-year horizon…A souring of global risk sentiment increases downside risks to growth at short time horizons of one quarter…Asset prices are most informative about risks to growth in the short term.”
“Augmenting growth forecast models based on past growth performance with financial conditions significantly improves forecasting ability.”
“Financial vulnerability is…the extent to which the adverse impact of shocks on economic activity may be amplified by financial frictions. Financial vulnerabilities…usually grow in buoyant economic conditions when investment opportunities seem ample, funding conditions are easy, and risk appetite is high. Once these vulnerabilities are sufficiently high, they can entail significant downside risks for the economy.”
“Theory and recent experience both support the view that financial vulnerabilities increase risks to growth. When investment opportunities seem abundant and the means of financing them are easily and cheaply available, financial vulnerabilities tend to increase.”
“Several factors cause financial vulnerabilities to grow in a buoyant macro-financial environment.
- Ease of borrowing and high asset prices reduce the incentives to manage liquidity and solvency risks.
- Perceptions of high investment returns relative to the cost of funding and of the improved quality of collateral incentivize households and firms to increase their leverage without taking into account the potential negative externalities resulting from their collective borrowing decisions.
- Booming asset prices also boost the capital adequacy, lending capacity, and risk appetite of financial intermediaries.”
“With vulnerabilities substantially elevated, even small negative shocks can cause significant reversals because they force lenders to face up to the true quality of exposures and collateral. This results in a significant tightening in credit conditions… Risk-bearing capacity will be affected not only by capital constraints but also by funding liquidity concerns.”
“Thus, incorporating information on credit aggregates such as leverage into measures of financial conditions may improve forecasts of risks to growth, especially over the medium term.”
Ideas for an integrated approach
“This interplay between shocks, financial vulnerabilities, and growth suggests that financial indicators can provide important intelligence regarding risks to the economic outlook…For example, a combination of low leverage and buoyant asset prices is likely to correspond, over the short term, to high expected growth…[Conversely] GDP growth responds nonlinearly to shocks in the presence of financial vulnerabilities, which increases the likelihood of severely negative economic outcomes. Under such circumstances, assessments of both the baseline growth outlook and the risks to such an outlook are informed not only by the span and severity of relevant risk factors that are the source of shocks, but also by the intelligence provided by the interplay of factors that increase financial vulnerability.”
“[We propose] a new, macroeconomic measure of financial stability by linking financial conditions to the probability distribution of future GDP growth and applying it to a set of major advanced and emerging market economies.”
“Financial indicators are partitioned into three separate groups based on economic similarity. The three sub-indices are the domestic price of risk (risk spreads, asset returns, and price volatility), credit aggregates (leverage and credit growth), and external conditions (global risk sentiment, commodity prices, and exchange rates). The separation provides a more direct economic interpretation of the various sub-indices.”
“While a widening of risk spreads, rising asset price volatility, and waning global risk appetite are significant predictors of large macroeconomic downturns in the near term, higher leverage and credit growth provide a more significant signal of increased downside risks to GDP growth over the medium term.”
“The [report] uses financial conditions to forecast the probability distribution of future GDP growth in major advanced and emerging market economies for horizons of up to three years through quantile projections…An increasing domestic price of risk signals an elevated threat of imminent, severe recession in advanced and emerging market economies. Rising leverage is a significant predictor of elevated downside risk over the medium term. Country-specific results vary considerably, suggesting a rich interplay of the drivers of growth risk.”