Financial conditions loosen further in warning shot to euphoric markets

By Naomi Rovnick

LONDON (Reuters) – Feverish speculation about future interest rate cuts has further loosened global financial conditions, storing up risks for euphoric stock and bond markets if central banks view the easy funding environment as a reason to hold borrowing costs high.

Global financial conditions, viewed as a leading indicatorof economic performance, are now at their most accommodative since early August, a widely followed index produced by Goldman Sachs showed on Friday.

The index, which broadly tracks corporate borrowing costs and how easily companies can tap stock markets for funding, remains close to its levels of March 2022. That was just before the U.S. Federal Reserve, the European Central Bank and other big central banks embarked on aggressive monetary tightening campaigns to bring inflation under control.

Goldman’s U.S. version of this index shows conditions are at their most accommodative since July 26.

The easing in financial market conditions reflects the pricing in of hefty interest rate cuts next year, undoing some of the recent monetary tightening by central banks that could in turn encourage policymakers to keep borrowing costs elevated longer than markets anticipate.

“You’ve got a lot (of monetary loosening) priced in, you’re already getting easier financial conditions,” TS Lombard global head of macro Dario Perkins said.

If central banks “do not validate these moves, if they don’t cut interest rates and they just sort of ignore it, then financial conditions are going to tighten again.”

Global stocks have advanced almost 4% this month after rising more than 9% in November in a rally fueled by rate cut bets.

The Dow Jones Industrial Average on Thursday notched its second straight record high close, European stocks are near their highest levels in almost two years and Asia-Pacific shares outside Japan on Friday hit four-month peaks.

After Fed officials projected on Wednesday that the world’s most influential central bank would lower the key funds rate by 75 basis points (bps) this year from a current 22-year high, markets ramped up rate cut bets and now price in almost 150 bps of cuts.

Similarly deep cuts are expected from the European Central Bank, which on Thursday attempted to rebuff this speculation.

Money markets also price in roughly 150 bps worth of European Central Bank rate cuts next year, up from around 135 bps on Wednesday, despite the ECB having on Thursday attempted to rebuff this speculation.

“We may be in a situation where financial conditions have eased in such a rapid and significant way that this could materially affect future growth and inflation,” Rabobank strategists said in a note.

Emmanuel Cau, Barclays head of European equity strategy, said “many investors” among hundreds he had met with recently had “struggled to see central banks cutting rates as much as expected.”

“Chasing the (stocks) rally at current levels is difficult,” he said.

(Reporting by Naomi Rovnick; editing by Dhara Ranasinghe and Sharon Singleton)