Market Stress? The Fed has a free app for that!（ZT）

青影

Stress AND Perspective go hand in hand in life and markets. Most importantly you can’t deal with stress properly with out perspective.

How stressed out are the financial markets?

So with so much talk about whether the Fed will not rate the Fed Funds rate because of ‘market stress’, I thought it would be a good time to see what the Fed uses to determine how stressed out the markets really are.
And it’s easy!

The Fed has its very own “Financial Stress Index” which it built in 2010 response to the financial crisis. Yes, 2010 was a little ‘behind the curve’ as usual, but nonetheless it’s a very interesting measure that provides good perspective on current and past market conditions going back as far as 1994.

Here’s how the St Louis Fed blog describes the reason for its index…

“In the aftermath of the financial crisis, arguments arose over how to monitor financial market developments, with measurement of “stress” in the market being a likely requirement of any regulator engaging in such monitoring…

In an attempt to avoid focusing on a single indicator at the expense of others, economists and analysts created composite indexes of several of these indicators.”

In the chart below you’ll see the see the Fed’s Stress Index in red and the S&P 500 in blue. The red dashed line is the current level of the Stress Index.



I find it interesting to see that while the stress level is at a four year high, it’s not even close to the levels it reached in the previous S&P 500 declines in 2010 and 2011.

So what’s the Fed likely to conclude? Are the markets really all that stressed out?

Here’s some important perspective…

Below is the same chart with more history. Unfortunately, the FRED database I used to create the chart only provides 10 years of S&P 500 data. However, you can see how the Stress Index became extremely elevated before the S&P 500’s major decline began in 2007.



also found it interesting to see how the index reacted in August 1998 when Russia defaulted on its local currency bonds and hedge fund Long Term Capital Management collapsed. This led to a quick 22% decline in the S&P 500.

The next peak after the Russian default correlates with a 15% decline in the S&P in October of 1999.

Then you’ll see the infamous top in 2000 labeled along with the tech wreck low in 2002. The peak in the S&P in May of 2000 was about 155 and the low of 2002 was 77. Interestingly, this represents a 50% decline in stocks, yet the Stress Index never exceeded its May 2000 high.

You might find it more interesting to find the S&P 500 Financials Index and the VXX are used in the calculation! The other 16 data sets are related to bond markets. So if you’re not already paying close attention to bond markets, perhaps you should.

You may recall this same Market Outlook from last week looked at a bond market relationship that you should probably keep an eye on for measuring the market’s confidence in stock (you’ll find it about 24 minutes into the video).

And if you’re curious… you can read more about the Fed’s index calculation here.

Will the Fed raise with the current level of financial stress?

As you can see that while the media focuses on the stock market and the more sophisticated media includes the VIX as their proxies for ‘stress’, the Fed has a much broader view.

And the Fed’s own Stress Index is not all that high!

So the next logical question is… Has the Fed raised rates with the Stress Index at these levels?

Below you’ll find the same chart as above with the Effective Fed Funds Rate overlaid.



I’ll point out that right after the Russian default crisis in 1998 the Fed raised rates aggressively while the Stress Index had readings of .5 to over 1. The Stress Index currently sits at -.5.

However, that time period did not end well.  Stocks collapsed by 50% along with a recession (shown in gray). The Fed may have learned from that.

The Fed also began a campaign of raising rates in early 2004 when the Stress Index was at the same level it is today. The trend of the index in 2004 was definitively down as opposed to definitively up as it is now. However, the raises continued even as the Stress Index appeared to turn up.

I’m sure you recall. That period didn’t end well either.

While it may sound like I’m making the case for not raising rates. I’m not. There are a lot more factors to consider than market stress, and the effective Fed Funds Rate is basically at 0 or even negative by some calculations (that’s topic for another article).

With the Effective Fed Funds Rate at the unprecedented level of .15 percent, and the historical perspective of the level of financial stress, I don’t think anyone should assume that the Fed will “wait” because the recent decline in stocks or rise in the VIX.

Finally, I didn’t write this article to persuade you one way or the other on the issue of the Fed’s interest rate decision.

More importantly, I think you should pay attention to the trend of the Fed’s Financial Stress Index because it will give you a good indication of trouble that you might not otherwise see coming if you’re just looking at common stock market indicators.

https://research.stlouisfed.org/fred2/graph/?g=1LHH

novice_trader

青影

novice_trader 发表于 2015-9-7 10:27 AM