FVI shows some heightened risks

The FVI shows that we are at heightened vulnerability in the economy, even with stronger growth. The FVI is perhaps a better indicator of the future than current GDP estimates, which are, at best, concurrent and, at worst, lagging. The hope is that GDP is gaining momentum. Unfortunately, this useful tool is only calculated through the first quarter of 2026. 

What is useful is that FVI can be broken into four subindices: valuation, funding, financial leverage, and household and business borrowing. Household and business borrowing looks to be under control. It is the government borrowing that is problematic. Funding risks have moved up quickly but have not reached elevated levels. Nevertheless, valuation and leverage levels are at extremes. My guess, without replicating the work, is that the subindex values have all moved higher given the current increases in interest rates. 

Financial Vulnerability Index FVI heading in wrong direction

Fed economists have developed a new Financial Vulnerability Index (FVI) that aims to provide a better long-term view of structural risks in the economy. The Fed’s Financial Conditions Index offers a short-term view of the financial environment. Still, the Fed’s new Financial Vulnerability Index (FVI) aims to capture structural issues and provide a longer-term perspective on sensitivity to stress. The index comprises 39 components across four sub-indexes: valuation pressure, household and business borrowing, financial leverage, and funding risk. 

This looks like a nice addition to the existing NFCI index.

One hopes this will become part of the FRED database and be updated on a regular cycle.

1. Valuation Pressures

• Focus: Overvalued asset markets.
• Function: Monitors whether asset prices (such as equities, real estate, and corporate bonds) are unsustainably high relative to economic fundamentals. High pressures mean the market is prone to sudden, damaging price corrections.

2. Household and Business Borrowing

• Focus: Nonfinancial sector leverage.
• Function: Tracks total debt levels building up within families and corporations. When businesses and households are over-extended, even minor drops in income can trigger widespread defaults.

3. Financial Leverage

• Focus: Financial sector risk-taking.
• Function: Measures the degree of debt and leverage being used within the financial sector itself (banks, broker-dealers, and hedge funds). High leverage means small asset losses can quickly wipe out a firm’s capital.

4. Funding Risk

• Focus: Systemic liquidity and structural maturity mismatches.
• Function: Evaluates the presence of volatile, short-term wholesale funding that could evaporate rapidly in a crisis (e.g., severe deposit runs or sudden freezes in overnight lending markets).

The GDPNow indicates growth is high

 

Why are long-term interest rates so high? One reason is that growth is well above trend, with the Atlanta Fed GDPNow forecasts for Q3 well above the Blue Chip consensus. The economy is doing well, which suggests that real rates should be higher. This could be embedded in bond rates, even though forecasters’ consensus is closer to 2.5%. Note that even at 2.5% growth with more than 3% inflation, nominal longer-term bonds should be above 5.5%. Now, is it likely that we will see real growth above 2.5% or 3% over the next 10 years? Unlikely, but if expectations are short-term focused, the bond market isn’t unreasonable.

The changing economics of China

 

China’s trade is evolving and has been described as China 2.0, a shift up the value-creation ladder from labor-cost advantages to more high-tech exports. To support growth, it has targeted high-tech exports to offset overall economic slowdown still driven by repricing of property risks.

Trade surpluses have continued to grow, with EVs, solar, and batteries being key drivers. China’s export growth has created significant economies of scale that will be hard for other countries to match. It is harder to raise trade barriers when the tariffs target goods needed to meet strategic environmental goals. The strategic move to high-tech manufacturing makes it harder to disengage with China. 

One of the only solutions is to innovate faster and leapfrog China’s high-tech manufacturing lead, but this is much easier said than done, and any innovation will take years to fully implement.

Dimension	China 1.0 (c. 1990s–2010s)	China 2.0 (c. 2020s–Present)
Primary Growth Engines	Property market, massive infrastructure investment, and domestic urbanization.	High-tech manufacturing, the “New Three” (EVs, lithium batteries, solar), and green technologies.
Export Profile	“China Shock 1.0”: Low-cost, labor-intensive, low-value-added consumer goods (clothing, toys, basic electronics).	“China Shock 2.0”: High-value-added industrial capital goods, advanced vehicles, industrial robotics, and clean-tech equipment.
Corporate Dominance	Real estate developers (e.g., Evergrande, Country Garden) and traditional heavy industries.	Advanced tech & industrial giants (e.g., BYD, CATL, Huawei, SMIC).
Policy Objective	Rapid, high-volume quantitative GDP growth (“Growth at all costs”).	High-quality qualitative development, technological self-reliance, and supply chain security.
Leverage & Debt Model	Rapid local government borrowing (LGFVs) and property sector leverage.	De-leveraging property, state-directed credit toward strategic high-tech manufacturing, and managed debt restructuring.
Global Trade Impact	Absorbed foreign investment; offered cheap labor to global brands.	Unprecedented trade surpluses, global manufacturing overcapacity, and direct competition with Western industry.