1 Reason For Market Rally? Financial Stress Has Returned To Mid-2007 Levels By 3 Fed Measures

Includes: DIA, KBE, QQQ, SPY
by: Mark J. Perry

Three Federal Reserve District Banks (Kansas City, St. Louis, and Chicago) calculate and report statistical measures of financial stress in the U.S. economy on a regular basis. Today the Kansas City Fed updated its monthly Financial Stress Index for March (see full report here), and the other two indexes (both weekly) were both just recently updated for the last week of March. Now that all three Fed bank stress indexes are available for the full month of March, they appear together in the chart below from January 2004 to March 2013.

Click to enlarge

Here's a summary of the March stress indexes:

1. The Kansas City Financial Stress Index (KCFSI), a monthly composite index of 11 variables reflecting stress in the U.S. financial system, fell in March to -0.63, which is the lowest index reading for the KCFSI since May 2007 (see blue line on chart). Negative values for the KCFSI indicate that financial stress is below the long-run average, and the KCFSI has been below zero for 14 consecutive months starting in February of last year.

2. The St. Louis Fed Financial Stress Index ((STLFSI)) is a statistical measure of financial market stress calculated using the principal components procedure based on 18 weekly data series that include seven interest rates, six yield spreads, and five other financial variables. Like the KCFSI, lower SLFSI index values indicate less financial stress. The STLFSI has been steadily trending downward for about a year and a half starting in October 2011 when the monthly average for the index was at 0.70 (red line on chart). For the month of March the STLFSI averaged -0.66, which is the lowest financial stress reading since July 2007.

3. The Chicago Fed National Financial Conditions Index (NFCI) is a composite index based on 100 different financial indicators, and has proven to be a highly accurate leading indicator of financial stress at horizons of up to one year. Increasing risk, tighter credit conditions, and declining leverage are consistent with tightening financial conditions and produce positive values for the NFCI, while negative values indicate the opposite conditions. The NFCI has been negative since late 2009, and has been trending downward since mid-2011 (see brown line on chart). In March, the NFCI average fell to -0.77, which indicates that the stress in U.S. financial markets is at the lowest level since May 2007 by this measure.

Based on these three different Federal Reserve bank measures of financial stress that have all shown a high degree of historical accuracy in assessing the amount of stress in U.S. financial markets, we can conclude several things: a) financial stress has been gradually falling since the fall of 2008, when all three indexes reached their cyclical highs, b) after reaching slightly elevated stress levels in the fall of 2011, all three indexes indicate that financial stress in the U.S. have been declining over the last 18 months, and c) all three indexes have returned to their pre-recession levels last seen in May 2007 for the Kansas City and Chicago Fed stress indexes and July 2007 for the St. Louis index.

The return of financial stress to mid-2007 by three different measures indicates that financial conditions have now normalized and stabilized at historical averages. Current financial stress levels are consistent with the conditions of an economy in recovery and are one reason that stock market indexes have been trading close to record highs in recent weeks. Lower financial stress equals higher stock market valuations.