As the Federal Reserve aggressively hikes interest rates to fight inflation, financial conditions have rapidly tightened across US credit markets. The sharp rise in borrowing costs and decline in loan availability threatens to cripple consumers, businesses, and investors that feasted on easy money during the pandemic era. While the full impact remains uncertain, sustained credit deterioration may strangle growth and tip the economy into recession.

Financial conditions reflect the overall availability and cost of credit in an economy. Quantitative easing and rock bottom rates from the Fed kept conditions ultra-loose after the pandemic hit, spurring demand. However, the central bank is now slamming the brakes to curb inflation.

The Fed’s benchmark rate has shot from near zero in March to 3.25% currently. Meanwhile, the Fed’s balance sheet shrinkage reduces liquidity by up to $95 billion monthly. Markets expect rates nearing 5% by mid-2023 with more liquidity draining to come.

As a result, key lending rates for consumers and businesses are spiking. The average 30-year fixed mortgage rate has doubled over the past year to around 7%, crushing housing affordability. More concerning, the 3-month LIBOR rate banks use for loans recently hit 4.3%, the highest since 2008.

Corporate borrowing costs have exploded in parallel. The yield on the ICE BofA US High Yield Index recently topped 10% for the first time since 2020. This not only pressures company profits and cash flows, but limits access to capital for business investment.

Weaker firms may get shut out of credit markets entirely. Deutsche Bank strategists estimate over 15% of S&P 1500 firms may be unable to cover interest expenses at projected borrowing rates, putting them at existential risk. If higher rates persist as expected, bankruptcies seem poised to jump.

Meanwhile, massive stock and bond market losses have compounded the tightening financial squeeze. With typical 60/40 portfolios down 15-25% YTD, the “wealth effect” of declining investments could further hamper spending.

“The double whammy of spiraling borrowing costs and crumbling asset prices may break growth,” warned Michael Hartnett, Bank of America chief investment strategist.

So far, consumers and businesses have proven resilient with solid savings and demand buffers. But as higher rates bite over coming quarters, vulnerabilities will deepen. Consumers may exhaust savings and increasingly default on autos, mortgages, and record credit card balances inflated by soaring prices.

Likewise, overstretched companies will slash investment outlays and hiring plans. With help from strong labor markets, the US may dodge recession in 2022. However, prolonged tightening raises red flags for 2023.

Some economists argue tighter conditions are a necessary cleansing after years of excess. “This purging of excesses built up during easy money periods can create the foundation for sustainable expansion ahead,” said Rock Creek Group global investment strategist Peter Cecchini.

However, the Fed must take care not to overcorrect. If conditions tighten too abruptly, credit markets could freeze entirely as seen during 2008. Given elevated leverage after pandemic stimulus, the risks of a credit crunch sparking financial turmoil and a severe downturn cannot be dismissed.

Whether US growth succumbs to the vice of tightening credit remains the central economic question ahead. As the Fed continues withdrawing stimulus, markets will scrutinize financial conditions closely for signs of cracks that may presage recession.

After years of credit exuberance, the reckoning has arrived. While recent resilience has provided hope, policymakers and investors seem laser-focused on this crucial barometer. With futures markets now betting on easing by late-2023, the stakes surrounding each basis point of tightening have become extraordinarily high.

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