Macro shocks and financial conditions – Goldman Sachs

Research Team at Goldman Sachs, suggests that they have argued that financial conditions drive much of the business cycle, but what drives financial conditions?

Key Quotes

“To answer this question, we use the comovement of different asset prices to infer shocks to the market’s assessment of growth, monetary policy, and foreign developments. We then use these macro shocks to explain moves in the FCI for each of the G3 economies.

Monetary policy shocks have the clearest impact because they move all markets in the same direction (in FCI terms). Foreign shocks also often have important FCI effects. In contrast, growth shocks usually have smaller effects because they move the different FCI components—e.g., bonds vs. stocks—in offsetting ways.

According to our model, the sharp tightening in G3 financial conditions in early 2016 was due to a triple whammy of weaker growth, adverse foreign shocks— with most worries focused on China—and tighter policy. In the US, this tightening has more than unwound, partly reflecting easier perceived monetary policy but mostly because of better news from abroad. Conditions in Europe and especially Japan have improved much less, as the markets still view both monetary policy and foreign influences as more adverse.

In general, our measure of perceived shocks lines up fairly well with measurable data or policy surprises. But when a gap opens up without a compelling explanation, opportunity beckons. For example, the sharp deterioration in perceived US growth in the first quarter presented—and perhaps still presents— a good opportunity to take a more constructive view. The tightening in perceived policy in Japan since late 2015 may likewise present an opportunity, assuming the BoJ’s true intention is still to ease.”