The press is filled with stories of banking failures and global financial crisis (GFC) analogies.
Equity markets have fallen ~3% this month (6% since the early February peak), and demand for safe haven assets has risen. But how much “stress” are markets actually indicating?
Our analysis suggests that in comparison to genuine “crisis” periods such as the COVID dislocation of 2020 and the GFC of 2008, most market stress indicators are still a long way from “extreme” levels.
In addition, key indicators of economic activity suggest conditions remain relatively solid, although a growth slowdown is widely expected (and we agree).
Below, we examine a number of key market stress indicators to gauge current market stress levels and provide our interpretation of what each indicator is currently signaling.
VIX: Equity Stress Still Contained
The VIX is perhaps the most widely followed measure of market stress or uncertainty. Strictly speaking, the VIX is a measure of implied volatility in the S&P 500 options market. As a result, the VIX tends to spike in periods of market volatility, or more particularly “risk-off” phases. While the VIX has risen in recent weeks, it is not at a particularly elevated level compared to genuine crisis periods. This reflects the fact that, at this point, the equity market correction is still fairly small and relatively orderly.
Our interpretation is that listed companies and the real economy are generally perceived to be in decent shape. Of course, a genuine banking crisis (which we judge is not the current state of affairs) could change this outlook. For now, the VIX is a long way from signaling an impending crisis.
More Stress in Bond Markets?
The interest rate equivalent of the VIX is the MOVE index. Once again, the MOVE index measures implied volatility premiums in the options market. In this case, it measures implied volatility for US treasury bond options. Importantly, it does not have any explicit “credit” dimension, being a purely government bond focused measure of volatility.
The fact the jump in the MOVE index has been much bigger than the jump in the VIX is an interesting development. One interpretation is that bond markets are warning of much more system stress than equity markets. However, it is important to note that while volatility measures have spiked, government bonds have actually rallied strongly this month, protecting diversified portfolios. We would suggest that the elevated level of the MOVE index is not so much a direct indication of stress as an indication of huge uncertainty around the path of official (i.e., US Federal Reserve) interest rates.
Expectations for Fed tightening over the balance of the year have shifted dramatically in the past 2 weeks, with the market both winding back the number of expected hikes and also reinstating several rate cuts later in the year. Expectations in this respect continue to move around on an almost daily basis.
Of course, to the extent that the US and (to a lesser extent) the global banking sector strains are the root cause of this Fed re-pricing, it is a signal that the market sees the potential for economic stress to follow this current banking stress. The market is essentially saying that the banking sector will not cope with much in the way of additional Fed tightening, forcing the Fed to “pivot”. While the Fed hiked again this past week, it did strike a more balanced tone, while suggesting another hike is probable.
The market has ~40% probability on the prospect of another near-term hike and is then factoring in 3 cuts. This suggests it expects the combination of Fed hiking and the tightening of bank lending standards to slow the US economy fairly quickly from here. So, we do concede the MOVE index is signaling caution, or potential vulnerability, in respect of the US economy. This is different to a signal of genuine systemic problems in the US financial system currently, but it is still noteworthy.
High Yield Corporate Bond Spreads
One feature of current banking sector strains is that they do not appear to be credit related. Banks are reporting little in the way of bad debt problems and corporate bond market default rates are still very low. A small number of US banks have gotten into trouble for holding too many US treasuries, not for having too many bad loans.
Of course, markets look forward and the rise in high yield bond spreads in the past 2 weeks suggests markets are becoming a bit more nervous on credit problems down the track.
On balance, however, the level of high yield spreads is still relatively contained, and is a long way from the highly stressed levels witnessed in previous crises.
For investment grade bonds, the move out in spreads is relatively moderate, suggesting investment grade bonds are still seen as an “investment grade” asset class. This is a very different scenario to what we saw in the GFC or the 2020 COVID crisis when stress spread across the credit quality spectrum.
TED Spread: Wider But Contained
The TED spread is the difference between the 3-month treasury bill and the 3-month LIBOR (interbank lending rate) based in US dollars. To put it another way, the TED spread is the difference between the interest rate on short-term US government debt and the interest rate on interbank loans. TED is an acronym for the Treasury-Euro Dollar rate.
Despite the banking sector origins of current market strains, there has not been a particularly large move in the TED spread. This suggests the market (or banks themselves) still sees the big money centre banks that dominate this measure as being fundamentally sound. If there are issues in banking, it seems concerns are concentrated in second tier or regional US banks. From this perspective, we are watching the regional bank equity index closely as it arguably is the unique feature of the current environment (see figure 6).
The Financial Conditions Index: The Fed’s Go-to Indicator
The Chicago Fed’s US Financial Conditions Index (NFCI) provides a comprehensive weekly update on US financial conditions across money markets, debt and equity markets, and both the traditional and “shadow” banking systems. The NFCI is a weighted average of a large number of variables, each expressed relative to their sample averages and scaled by their standard deviations. Specifically, it composes variables such as risk-free interest rates, the US$ exchange rate, equity price/valuation changes, credit spreads and system liquidity measures.
Being a summary measure of a lot of financial system data and many markets focussed indicators, the NFCI is the measure the Fed follows most closely in terms of gauging financial system stress and health.
Any significant tightening in financial conditions is an important consideration in terms of the Fed’s willingness to keep tightening or start easing. This index has moved up (financial conditions have tightened) but it has not been a huge move in the context of previous periods of financial system stress. This partly explains why the Fed lifted rates again this week and signalled another hike is probable.
Market Nervous but likely to Focus back on Fundamentals
In conclusion, our analysis of market stress indicators suggests markets are a long way from the hyper-stressed or genuine crisis states we have witnessed (rarely) historically – e.g. the 2008 GFC. At this stage, the backdrop seems more akin to one of the periodic volatility spikes that have occurred regularly over the past 30 years.
The MOVE (interest rate volatility) index is the indicator that stands out as being close to several standard deviations from normal levels. As discussed, this is arguably not so much an indicator of severe current market stress but an expression of a heightened fear that the Fed could overtighten, causing a recession, a genuine banking crisis, or both. Importantly, we do not see a credit dimension to current banking strains, so the Fed still has some wiggle room. Confidence is jittery, but the real economy continues to look robust.
We expect the most likely scenario is for markets to settle down and focus back on growth and inflation fundamentals. While there are still risks in this fundamental backdrop, we do see prospects as looking encouraging for a relatively orderly slowdown in both growth and inflation. This should see equity markets lift again in response. However, in the interim we will continue to watch our stress indicators closely for warning signs of more severe strains.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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