With accommodative central bank policy feeding into low stock market volatility worldwide, tight corporate bond spreads, and other indications that financial market worries remain at low levels (such as report this week in the Wall St. Journal that home equity loans are becoming popular again), we thought it would be interesting to capture where current financial conditions stand in a single, clean indicator.
As such, we used three financial system stress indices produced by various Federal Reserve branches in combination with the Conference Board’s Leading Credit Indicators Index to produce a single indicator showing that, indeed, we’re observing a period of accommodation and low financial stress that rivals the go-go financial system days of the mid-2000s.
Quickly, how did we construct our index? We took the 4-month moving averages for the St. Louis Fed Financial Stress, Kansas City Fed Financial Stress, Chicago Fed National Financial Condition, and Conference Board indices going back to 1994. Then, we calculated the Z-scores (standard deviations away from average) for the 4-month moving averages in each of the indices. Finally, we averaged those z-scores across the four indicators to produce the final indicator.
How do organizations like the Federal Reserve Banks and Conference Board construct financial system indices? The Conference Board, for instance, uses a variety of financial market indicators such as swap spreads, the TED spread, margin and debit balances, and national bank loan surveys to construct their index. The Chicago Fed uses 105 different financial market indicators to construct an index, many relating to loan surveys and various interest rate and swap spreads as well.
Here is a visual representation of the work:
As you can see financial system stress remained below average through the mid-1990s until the time of the Asian/Russian/LTCM financial crises drove financial system stress higher. Stress remained elevated through the market turmoil and recession from 2000 to 2002. Coming out of the early 2000s recession, financial stress declined markedly, reaching a bottom in 2005 at approximately the same time the real estate boom was nearing a peak and central bankers in the US started talking about the so-called “global savings glut.” Stresses started to increase dramatically in mid-2007 as the markets glimpsed the first signs that the leveraged financial products markets associated with the housing boom were beginning to crack. As the worst financial crisis since the Great Depression unfolded, we see a dramatic spike in system problems. The highest level of stress in our indicator was reached in December 2008 near the very height of the Great Recession. Coordinated global central bank actions pulled us back from the brink through 2009 and financial system conditions have continued to improve since then, except for a few spikes associated with the European turmoil during 2010 and 2011. Interestingly, the lowest level ever recorded in this index occurred in February of this year. The index isn’t far removed from those lows; financial conditions remain very accommodative.
What are some takeaways from looking at this data?
Over the past 20 years, the two big equity market downturns in the US and globally happened several months to a couple of years after these financial stress indices began showing bottlenecks in the system and spiked higher, well above zero. Looking at the current market situation, while this isn’t a primary indicator we use to drive risk allocations, we think this meets up with other indicators that we use showing that the risk for a major market calamity are reasonably low at present, even though long-term valuations in the US are somewhat stretched. For instance, leading economic indicators here and abroad show the risk of recession over the coming year remains very low. And, general longer-term market technical indicators remain favorable. Until we see indicators like this begin to grind noticeably higher and above the zero-line, we’ll remain sanguine about the intermediate-term path of equity market prices.
That said, the contrarian gremlin in us notes the extreme low stress level in this index will have to unwind at some point. Looking across markets and asset classes, it’s hard for us to see, for instance, how high-yield corporate debt spreads could get much tighter. Granted, this index remained at extremely low levels for three or four years ahead of the Great Recession. When benign conditions unraveled, however, the unprecedented long period of calm morphed into an unprecedented period of stress. Just as risk and reward can be symmetrical when looking at equity markets, there’s a symmetry to indicators like this. Big deviations to the downside tend to lead eventually to big deviations on the upside. We’ll certainly keep an eye on this and other market indicators for signs that trends are changing.
