Wednesday, February 11, 2015

Financial Stress Indicators - Predicting Economic Health

There is one relatively little reported on economic measure that can give us a sense of where the economy is headed and that allows economists to monitor the amount of stress that is building in the economy.  This measure monitors the financial system and identifies risks that threaten the financial stability of the U.S. economy both at present and in the future. 

The Cleveland Financial Stress Index (CFSI) tracks distress in the U.S. financial system on a continuous basis.  Since financial stress can build rapidly, this measure gives economists an early warning when stresses are building in the economy from several sectors.  The CFSI was developed by the Federal Reserve Bank of Cleveland and incorporates information from financial markets to ascertain where stress may be building in the system.  The CFSI tracks the credit, equity, foreign exchange and interbank sectors and uses a total of 11 components, most of which are "spreads", for instance, the gap in yields, prices or rates of different financial instruments.

Here is a listing of the components by sector:

1.) Credit:

a) Covered Interest Spread: This spread measures the difference in yield between the 90-day U.S. Treasury yield and the 90-day U.K. Treasury yield.  This provides policymakers with information about uncertainty in government bond markets where a widening spread indicates unwillingness to hold a government's debt which signals the onset of stress.

b) Corporate Bond Spread: This spread measures the difference in yield between the 10-year U.S. Treasury and the 10-year Moody's Aaa-rated corporate bond.  This provides policymakers with information about medium- and long-term corporate risk.  When the spread increases, there is increased risk of businesses having problems financing debt which signals the onset of stress.

c.) Liquidity Spread: This spread measures the changes in the short-term differences in bid and ask prices on three-month U.S. Treasuries.  A widening spread indicates illiquidity in the market which signals growing stress.

d) Treasury Curve Yield: This is calculated as the difference between the yield on three-month and ten-year U.S. Treasuries.  This captures the combination of both long-term uncertainty and short-term liquidity needed at the beginning and during a recession.  It is a useful predictor of both recessions and real economic activity.

2.) Equity:

a) Stock Market Crashes: This indicator measures the radio of the current value of the S&P 500 financial index compared to its maximum over the previous 365 days, capturing the extend to which equity values have dropped over the previous year and provides information on expectations about the future condition of the financial services industry.  A high value signals growing stress.

3.) Foreign Exchange:

a) Weighted Dollar Crashes: This indicator measures the radio of the current value of the trade-weighted U.S. dollar exchange index relative to the maximum for the previous 365 days, measuring the flight from the U.S. dollar toward a set of foreign currencies.  It signals increased demand for liquidity from the domestic financial system that may require unanticipated and inefficient lending which signals growing stress.

4.) Interbank:

a) Financial Beta: This is measured as the volatility of share prices in the banking sector compared to volatility in the overall market.  This signals potential insolvency and strains on bank profitability compared to the wider economy.

b) Bank Bond Spread: This spread measures the difference in yield between the 10-year A-rated bond and the 10-year U.S. Treasury.  It captures the perception of medium- and long-term risk in banks that issue A-rated bonds.

c) Interbank Liquidity Spread: This spread is measured as the difference between the three-month LIBOR and the three-month U.S. Treasury yield.  This captures the perception of counterparty risk in interbank lending and increases when market liquidity is scarce or when counterparty default risk increases, both of which signal growing stress.

d) Interbank Cost of Borrowing: This spread is measured as the difference between the three-month LIBOR and the federal funds rate.  Its function is similar to the Interbank Liquidity Spread.

The CFSI is divided into ranges which are assigned to four categories/stress grades which measure the severity of distress with ranges of values and assigned probability of a systemic stress episode: as shown here:

Here is a graphic showing how the CFSI works during a set of crises:

Now, let's look at current data.  From FRED, here is a graph showing the CFSI going back to 1998:

The CFSI bottomed in early 2014 and has risen slowly but surely since then.  It is certainly not at the elevated levels that it saw during the Great Recession, however, this is the first time that it has been into positive territory since early 2013.  As well, its rather abrupt rise is worth watching over the near-term.  

As I noted above, one of the contributors to the CFSI is "Stock Market Crashes".  As we can see on this graph from FRED, this component is at elevated levels, reflecting the current volatility to the downside in the stock market:

As shown on this graph from FRED, the "Treasury Yield Curve Spread" is also showing rising levels of stress:

It is also interesting to see that stress levels in "Liquidity Spread" are at levels that have remained elevated since the Great Recession as shown here:

If you are interested in following this posting in greater depth, I would recommend that you go to the Federal Reserve Bank of St. Louis Economic Research webpage and look through the graphs for each of the components of the CFSI as found here.

Not only does the Cleveland Financial Stress Index provide policymakers and central bankers with a tool that enables them to analyze the economic components that are contributing or will contribute to future economic problem areas, it can be used by those of us that are non-professional economy watchers to give us a heads up about where problem areas in the economy may develop.  

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