The KCFSI is a monthly composite index of 11 variables reflecting stress in the U.S. financial system. These variables fall into two broad categories--average yield spreads, and measures based on the actual or expected behavior of asset prices. The index is calculated using the principal components procedure. Under this procedure, the coefficients of the 11 variables are chosen so that the index explains the maximum possible amount of total variation in the variables from February 1990 through the current month.
A positive value of the KCSFI indicates that financial stress is above the long-run average, while a negative value signifies that financial stress is below the long-run average.
The Kansas City Financial Stress Index (KCFSI) was -0.28 in December, down moderately from -0.12 in November. With the decrease, the index remained below its long-run average of zero and moved near its low for the year, reached in March.
The near-collapse of the global financial industry in late 2008 sent a tsunami of fear throughout the global financial markets and temporarily paralyzed global economies. Activity in many areas ground to a halt as consumers hoarded cash, institutional investors scrambled to sell risky assets, and everyone tried to deleverage. Fear was the common denominator, as captured by the VIX Index (the implied volatility of equity options), and it peaked in late October 2008.
Two years ago the financial markets were priced to an "end-of-the-world-as-we-know-it" scenario. Today financial markets are beginning to realize that a return to "normalcy" is possible and within reach. We should all breathe a great sigh of relief.