What to watch as interest rates rise

Monitoring central bank interest rates isn’t the only way to gauge how tight credit conditions are in markets.

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Our cover story is all about the underlying factor behind the market declines we've seen this October the receding of the liquidity tide and tightening of credit conditions. However, it's worth digging deeper into what we mean by this. When you think of credit conditions, you might think of central bank interest rates. This is certainly part of it. But as Joe Weisenthal points out on Bloomberg, there's a lot more to the financial environment than central bank interest rates alone.

When we talk about financial conditions being tight or loose, we're essentially referring to how easy or hard it is to borrow money (and what it will cost you to do so). When financial conditions are loose, it's straightforward to get loans at low interest rates, without onerous conditions attached. That's the sort of environment we have enjoyed for much of the past decade at least until this year.

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Several indices try to measure financial conditions one of the most popular is the Goldman Sachs financial conditions index, which has several components, and which rose steadily this year before spiking last month. One is the strength or otherwise of the US dollar (measured against a basket of the currencies of its biggest trading partners). As the global reserve currency the most widely-used currency in the world the dollar is involved in most key areas of global trade or finance. As a result, most countries need a steady supply of dollars, which means that when the dollar becomes stronger, and thus more expensive to acquire, it effectively tightens financial conditions across the globe.

The Goldman Sachs indicator also looks at both short-term interest rates and longer-term ones, as measured by US Treasury rates. The US government is deemed one of the most creditworthy borrowers in the world. So to take the added risk of investing in any other asset, you would theoretically have to expect to get a better return than you'd get from holding a US government bond for the same period. As a result, if US Treasury yields go up, it suggests that expected returns on other assets have to rise, too and one way for that to happen is for asset prices to fall.

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In a similar vein, the index also looks at credit spreads the gap between the interest rate offered by borrowers with good credit ratings and those with bad credit ratings. When spreads start to expand, it shows that investors are growing increasingly fussy about credit risk and who they choose to lend to. So what should you keep an eye out for? If conditions are going to loosen up and markets enjoy an extended bounce chances are we will see it in the dollar first. But if the dollar doesn't weaken, don't be surprised to see last month's volatility continue.

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