Key Points

  • With all the focus on tariffs, trade, and the FAANG stocks; lost among those headlines is perhaps a more important fundamental reversal in financial conditions.

  • The blowout in LIBOR-OIS is technical in nature; but higher funding costs and tighter liquidity conditions still have market implications.

  • Volatility is not leaving the building anytime soon.

The cost and availability of credit directly affects the supply and demand dynamics of the stock market. Tightening financial conditions alongside tighter monetary policy have been less-discussed reasons for heightened volatility and weakness in stocks this year; but they will remain an important fundamental backdrop for equities. This report will step away from the headlines around tariffs, trade, and the FAANG stocks; and look more broadly at the important change in the character of the economic environment as it relates to financial conditions and stocks.

Tighter credit, timeless implications

We live in a globalized world—more so now than ever before—and are emerging from an era of unprecedented global monetary policy intervention. This makes the cycle more complicated than ever before; however, tighter credit conditions have relatively timeless implications. One thing appears a certainty: U.S. total debt levels are at record highs, and as a result, it’s worth considering whether even a mild increase in interest rates will hurt the economy via increased debt service costs.

Not only are short-term interest rates on the rise courtesy of a Federal Reserve which has been hiking rates since December 2015; longer-term rates are generally rising as well. With the former rising faster than the latter, the yield curve has been flattening over the past year (more on that in a bit). But liquidity is tightening via other channels as well—including the shrinkage in the Fed’s balance sheet, which began last fall. The chart below shows the drain to-date for just the Fed’s Treasury holdings (excluding the drain also underway of its mortgage-backed securities).

The Great Balance Sheet Shrink

Source: Charles Schwab, FactSet, as of April 6, 2018.

The balance sheet shrinkage program is in its third quarter of operation, with the run-off in Treasuries currently capped at $18 billion/month. But in the first quarter of this year, according to TS Lombard, there were two weeks when the combined liquidity provision of the Fed and the European Central Bank (ECB) was negative, because the Fed’s balance sheet shrank more than the ECB’s expanded. And it’s expected that by the end of this year the ECB will finish its quantitative easing (QE) operations, making liquidity contraction the norm instead of the exception.