Wednesday, October 7, 2020

No stress in the markets, but it has a way of sneaking up on investors

Following financial stress indicators is a good way of cutting through the verbal rhetoric and watching what markets are really doing. The current reading shows a low stress environment, not as low as a year ago before the pandemic, but significantly below spring levels. Stress measures have been stable for the last two months.

There are financial stress indicators from brokerage firms and banks. Additionally, they are available from Fed banks and other government institutions. The Office of Financial Research (OFR) calculates a daily financial stress index (FSI) using 33 financial variables divided into five categories: credit, equity valuation, funding, safe assets, and volatility. The variables are all publicly available and the categories values are also published. This FSI also shows stress by region. The index is zero when the average is zero.

The credit category focuses on corporate spread levels which have stabilized since spring. The equity valuation is centered on price to book ratios. The funding section has seven measures of short-term dislocations like 3-month LIBOR-OIS spreads. The safe asset category focuses on demand for assets like Treasury bonds, gold, the dollar, and yen exchange rate. The volatility category includes volatility measures in stock, bonds, currencies, and commodities. 

While the current index levels are showing below average stress, a close look at historical data is that stress indicators shift quickly with limited advanced warning. A switch from negative to positive values should be a concern. A decline in stress is usually associated with Fed action to directly offer stabilization. For the near-term, investors should focus on near-term stress from election concerns and not poll numbers or talking heads. 


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