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Financial Stress Indexes Rising (Again) at Trader’s Narrative

Financial Stress Indexes Rising (Again)

In April, when the stock market was going full throttle, I shared with you the chart of the 10 year Greek bond yield because it seemed to have become a relatively good predictor of the US equity market. The yield continued to climb well after that culminating at 12.45% in early May.

The only thing that broke the parabolic rise was the announcement of concerted action from the EU in the form of a 750 billion bailout package. Within days, yields crashed down to 7.24% but then a funny thing happened:

greek bond yields Jun 2010

Rather than continue to fall and return to its historic norm, it started to slowly creep back up again. The bond market was not a believer in the bailout. After all, where exactly are debt laden countries supposed to get money with which to bailout other debt laden countries?

Another financial stress index is the TED spread (the difference between the Eurodollar 3 month rate and the 3 month US T-bill rate) started to also rise:

ted spread Jun 2010

On the plus side, the TED spread is well off the highs from 2008. And it is still close to its long term average. But the relentless rise from a bottom in March 2010 is potentially worrisome, especially if it continues to rise.

Another way to measure the financial stress in the markets is through the St. Louis Fed’s Financial Stress Index which aggregates several components, including the TED spread:

Interest Rates:

  • Effective federal funds rate
  • 2-year Treasury
  • 10-year Treasury
  • 30-year Treasury
  • Baa-rated corporate
  • Merrill Lynch High-Yield Corporate Master II Index
  • Merrill Lynch Asset-Backed Master BBB-rated

Yield Spreads:

  • Yield curve: 10-year Treasury minus 3-month Treasury
  • Corporate Baa-rated bond minus 10-year Treasury
  • Merrill Lynch High-Yield Corporate Master II Index minus 10-year Treasury
  • 3-month London Interbank Offering Rate–Overnight Index Swap (LIBOR-OIS) spread
  • 3-month Treasury-Eurodollar (TED) spread
  • 3-month commercial paper minus 3-month Treasury bill

Other Indicators:

  • J.P. Morgan Emerging Markets Bond Index Plus
  • Chicago Board Options Exchange Market Volatility Index (VIX)
  • Merrill Lynch Bond Market Volatility Index (1-month)
  • 10-year nominal Treasury yield minus 10-year Treasury Inflation Protected Security yield (breakeven inflation rate)
  • Vanguard Financials Exchange-Traded Fund (VFH)

You can get more information about it from the St. Louis Fed website. The interesting thing to glean from this chart is that, unlike the TED spread, the St. Louis Financial Stress index never really returned down to “normal” levels (below zero):

St Louis Fed Financial Stress Index Jun 2010

For data junkies, there is also the Kansas City Financial Stress Index which is a similar composite. But it is updated monthly, rather than weekly. The latest index data is for May (+0.31) which is showing a similar increase from the previous months level (-0.24 in April).

To conclude, these types of data are telling us little more than what we already know. The world economy is fragile. The response of world governments to the credit and debt crisis has been to substitute sovereign debt in lieu of private debt held by financial institutions. The plan was that, things would return to normal and then things could be unwound. The problem is that stresses are not subsiding.

It is important, however, to keep in mind that the stock market and the economy are two separate and distinct animals. While the challenges facing the credit market are real and continuing, I don’t think we can necessarily build a case for there to be a direct effect on the stock market. While indicators like the ones above or the ECRI’s Weekly Leading Index’s downturn get a lot of attention, a look back at history will be enough to show that they are not a helpful guide, in the short to intermediate term, for navigating the stock market.

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