Financial Stress Is Moderating, At Least by Some Measures

The measures of financial stress based on short-term markets are looking much better, though bond-market related measures are slow to improve. The most popular measure of stress is the TED spread, which is the difference between interest rates on inter-bank loans (LIBOR) and Treasury Bills.

We're getting so close to normal that some complacency--but that would be a mistake. The low TED-spread probably reflects central bank and government guarantees of bank borrowing.

Another measure of stress in short-term markets is the interest rate spread between the safest commercial paper and somewhat riskier paper, which is the difference between A2P2-rated paper and AA-rated paper.

There may be some implicit guarantee helping the spread, but not as much as in the case of bank debt. This is very good news.

Bond market stress measures continue to improve, but have not yet come down to normal levels. BAA bonds are investment grade (if you believe the ratings agencies), and we can compare their yields to 10-year Treasury Bonds.

My final measure of stress is the spread of junk bond interest rates over the 10-year Treasury

Economists at the Kansas City Federal Reserve Bank have recently developed a more comprehensive index of financial stress that incorporates 11 components. The developers of the index, Craig S. Hakkio and William R. Keeton, have written up their results in a good article, which though somewhat lengthy provides a good primer for those who want to learn more. They don't seem to be posting their data online yet, but the charts in their article suggest a relatively small drop in financial stress since the October 2008 peak.

Comments

[Mad Hedge F...:]

Janet Yellen thinks so. Financial markets are now in better condition than we imagined possiblesix months ago. However, the pace of the recovery will be frustratinglyslow, and it could take several years to return to full employment.Since the majority of the Fed board members feel that inflation will bestuck at 2% for years to come, deflation presents a greater risk thaninflation. We are not by any means out of the woods yet. Rising energyprices and interest rates are a potential drag on the economy.Commercial real estate is at the top of her worry list, as fallingrents and capital values could create a downward spiral, furtherimpairing the banks. China’s wishes for an alternate reserve currencyare impractical. Answering questions as only a UC Berkeley professorcan, she further confirmed my belief that we are looking at an “L”shaped recovery at best (see www.madhedgefundtrader... and www.madhedgefundtrader... .However, she did pour some cold water on my idea that the TBT hasfurther to run. “Inflation running up to untoward levels doesn’t makeany sense,” she averred.

Jul 05 11:41 AM

[CautiousInv...:]

I agree with the author that financail stress, for the time being, is moderating as evidenced by the various spreads.

Banks, however, are not lending except to corporations with the highest credit; larger companies without great credit, smaller companies and consumers are borrowing very little. Whether this is a demand or credit availability matter I'm not certain.

Longer-term, though, I think the combination of legacy securities and assets, a protracted recovery and much lower financial sector earnings will put the financial sector back in the spotlight complete with sirens and widening spreads.

Jul 05 12:13 PM