European Daily: Q&A on the Euro Area FCI

• Our Euro area financial conditions index (FCI) has tightened about 60bp since mid-November, driven by higher long-term yields and lower equity prices, with modest contributions from spreads and the Euro. Viewed across member states, the tightening has been broad-based, but with more tightening in Italy than in Germany and France.
• We estimate that the FCI tightening stems primarily from a shift in expectations towards earlier ECB policy normalisation, with a limited effect from growth and the Fed’s hawkish turn (as upward pressure on Bund yields from a faster Fed exit has largely been offset by downward pressure on the Euro).
• Our analysis suggests that the Euro area “FCI impulse”—which shows the effect of lagged financial conditions shocks on GDP growth—is set to turn from positive in 2021 to a drag in 2022H1, consistent with the significant downgrade to Euro area growth we made at the start of the Russian invasion of Ukraine.

Q&A on the Euro Area FCI

Following the notable tightening of our Euro area financial conditions index (FCI) since the middle of November, we address some of the questions we have received in Q&A format.

1. How is the Euro area FCI calculated?

Our area-wide FCI is a combination of the individual country FCIs. Each country FCI is calculated as a weighted average of the Euro area three-month OIS rate, the 10-year Bund yield, the sovereign bond spread over the Bund, a corporate credit spread, an equity price variable, and the area-wide trade-weighted exchange rate (Exhibit 1). The weights mirror the effects of the financial variables on real GDP growth in our models over a one-year horizon. Our FCIs are updated daily, and are published on Bloomberg.

Differences in weights across economies reflect differences in financial systems and economic structures. Economies with larger shares of variable-rate borrowing have larger weights on the short-term rate. Sovereign spreads play a more important role in the periphery than the core, while the reverse is true for corporate credit spreads. Equity prices have a smaller FCI weight across Euro area members than, for example, the US. But the exchange rate plays a more important role than in the United States, especially for the most open Euro area economies (such as Germany).

2. How much have financial conditions tightened across Europe?

The area-wide FCI had tightened by about 80bp between mid-November and early March, and currently stands about 60bp tighter than the November lows (Exhibit 2). While substantially smaller than the 100bp tightening observed in our US FCI over this period, the Euro area move is sizeable in historical context.

Looking across components of the FCI, most of the tightening since late last year reflects higher long-term yields and lower equity prices, with modest contributions from spreads and the Euro (as a weakening against the Dollar has been broadly offset by a strengthening across Eastern European currencies). Viewed across countries, the tightening has been broad-based, with tighter conditions in all the major EMU economies, but more tightening in Finland, Austria and Italy than in Germany and France.

3. What has driven the tightening in financial conditions?

We use the cross correlation of asset prices—a statistical model with “sign restrictions”—to disentangle the underlying macro drivers of the tightening in financial conditions. To do so, we label any circumstances in which yields, equities and the exchange rate move in the same direction as “domestic growth shocks”; any circumstances in which yields and the exchange rate move in the same direction but equities move in the other direction as “domestic policy shocks”; and any circumstances in which yields and the exchange rate move in opposite directions as “foreign” shocks.

Exhibit 3 shows the resulting decomposition for 10-year Bund yields and the trade-weighted Euro. We see that the rise in long-term yields since early December has been driven primarily by market expectations of tighter monetary policy, both at home and abroad (left chart). Our model suggests that the main effect has come via pricing of tighter policy abroad in recent weeks, consistent with the significant shift in Fed rhetoric. Exhibit 3 (right) shows that the shift towards tighter policy at home and abroad has pulled the trade-weighted Euro in opposite directions, with little net change since December.

We then combine our estimated macro decompositions for yields, equity prices and the Euro into contributions to the FCI.1 We see that expectations for monetary policy normalisation have dominated the tightening in Euro area financial conditions (Exhibit 4, left). The FCI tightening stems from priced ECB shifts, with a limited effect from the Fed’s hawkish turn (as upward pressure on Bund yields has largely been offset by downward pressure on the Euro). That said, the policy-driven tightening in the Euro area FCI looks modest compared with that seen in the US (Exhibit 4, right).

4. What’s the effect of the recent FCI tightening on growth?

Our FCI has meaningful predictive power for growth in the Euro area. To show this, we estimate a simple statistical model with area-wide real GDP and our FCI, estimated with quarterly data since 1999.2 We then use the estimated model to trace out the impact of an FCI shock on real GDP, as shown in the left panel of Exhibit 5.3 We see that a persistent 100bp FCI tightening usually lowers the level of real GDP by about 1% after one year.

Following our previous work , we use these estimates to generate an “FCI impulse” for Euro area growth, defined as the effect of lagged financial conditions shocks on GDP growth. This impulse provides a summary of how financial conditions are influencing growth at any point in time. Exhibit 5 (right) suggests that the FCI impulse is set to turn from modestly positive in 2021 to a moderate drag in 2022H1 in response to the tightening seen since the middle of November, consistent with the significant downgrade to Euro area growth we made at the start of the Russian invasion of Ukraine.

5. How does the ECB affect the FCI?

The Governing Council can affect financial conditions using its range of tools, including the deposit rate, forward guidance (or the “path” of interest rates), QE and credit (or “spread”) policies. Using our monetary policy shock framework , we find that policy rate shocks tighten the Euro area FCI primarily through the risk-free curve and the exchange rate, whereas QE and credit shocks typically have larger effects on the risky parts of the FCI (Exhibit 6). ECB Executive Board Member Schnabel has recently argued that the superior control of the stance through policy rates reflects the benchmark nature of short-term rates in the still largely bank-based Euro area economy .

Looking ahead, we expect the Governing Council to end net APP purchases in Q3 (most likely in July), followed by policy normalisation through rate hikes. We look for 25bp hikes in each of September and December this year, three hikes in 2023 and a terminal rate of 1.25%. But we see risks skewed towards a faster pace and a higher terminal rate, particularly if significant second-round effects emerge in inflation expectations and wage-setting.