How Does Stress in the Financial System Compare to 2008?
In the wake of the financial crisis, the staff at the Kansas City Federal Reserve built a new index designed to measure financial stress, using data as far back as 1990. The index is designed to measure various aspects of financial stress, including uncertainty regarding asset valuations, concerns over safety and liquidity, the behavior of other investors and the asymmetry of information. During the crisis in October 2008, the index measured almost six standard deviations above its historical average before ultimately receding down to that longer-run average in 2010.
The latest reading of this index was published last week. It showed some improvement in April to a level of 1.64 standard deviations above average, down from the recent peak of 2.1 in March1. The index is comprised of eleven financial variables, six of which are various spread relationships, including the TED spread, 2-year swap, three measures of corporate bond-Treasury spreads, and a consumer ABS-Treasury spread. It also includes the VIX index and two measures of the relative performance of bank stocks. Lastly, it includes the correlation between Treasuries and stocks.
A Strong Banking Sector and Swift Action from Washington Have Reduced the Level of Financial Stress
April’s improvement came primarily from a decline in the VIX and some relative improvement in the performance of bank stocks. While the composite index is published monthly, its individual indicators can be accessed in real time, providing timely insight into the degree of stress in the financial system. While these indicators are currently elevated relative to their longer-term historical averages, it is clear that the degree of financial stress being experienced now is significantly below the level experienced during the financial crisis. That is no doubt due in part to the sizeable and timely policy response from Washington this time, but also the relatively stronger banking sector.
Also, last week, the Federal Reserve Bank in Washington released its latest financial stability report2. It is designed to examine the vulnerability of the financial system to a potential shock, an objective that is different, albeit related, to what the Kansas City Financial Stress Index is attempting to measure. The stability report focuses on four areas; asset price valuations, the level of borrowing in the private sector, the degree of leverage in the financial system, and funding risk. Not unexpectedly, the Fed pointed out that risk in all four of these areas is currently elevated due to the coronavirus and the efforts to fight its spread. Taken together, these two reports can provide insight into the thinking of the central bank, and where it believes weaknesses and stresses appear in the financial system.
Additional Measures of Stress Needed at the Industry and Company Level in the Current Environment
Of course, there are numerous other metrics that can provide insight into financial stress, such as loan delinquency trends, and rating agency actions, but in the current environment, where corporate revenue has in some cases dried up overnight, there is a need for additional measures of stress at the industry and company level to provide investors with timely, virtually real time, insight. Airlines, restaurant chains, retail stores and hotels are examples of industries where daily tallies of capacity, traffic and occupancy are essential to identify whether an improving trend as the economy reopens will be sufficient to prevent a liquidity crisis from becoming a solvency crisis. Comparing these trends against all available sources of cash can provide a measure of a corporate entity’s ability to remain solvent, and for how long. In the absence of revenue, those sources of cash will include retained earnings, untapped lines of credit, potential employee layoffs, the sale and leaseback of hard assets, suspended or cut dividends and buybacks, access to federal loans and so on. But any analysis will necessarily involve a good deal of guesswork. It is uncertain when consumers will feel comfortable enough to return to normal, and whether that will be soon enough to generate revenue sufficient to allow companies to remain solvent, once other sources of cash have been exhausted.
The Fed responded to rising overall liquidity risk in the corporate bond market back on March 23 by launching, among other programs, the primary and secondary market corporate credit facility, designed to leverage $75 billion of equity from the Treasury Department for the purchase of both existing and new issue corporate bonds. That program was activated last week with the initial purchase of ETFs totaling $305 million, yet there was very little discernable market reaction as the Fed had, in fact, accomplished its goal of unclogging the corporate bond market simply by announcing the new credit facility back in March, making it unlikely that the Fed will need to be particularly active in utilizing the new facility. In fact, the month of April saw a record amount of new investment grade corporate bonds issued, totaling $300 billion. Between February 19 and March 23, the spread of BBB corporate bonds over Treasuries climbed from 131 basis points to 488. Following the Fed’s announcement, the spread immediately began to contract, falling to 282 basis points by the end of April, two weeks before the Fed’s first purchase of corporate bond ETFs.
But improved credit market liquidity will be of little help to companies that can neither access credit facilities nor bond markets at a sufficiently attractive price to offset a cash burn that threatens to drive them to insolvency.
Sources: Factset, Bloomberg
1News Release, The Federal Reserve Bank of Kansas City, May 11, 2020.
2Financial Stability Report, Board of Governors of the Federal Reserve System, May 15, 2020.
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The Kansas City Financial Stress Index (KCFSI) is a monthly measure of stress in the U.S. financial system based on 11 financial market variables. A positive value 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 Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a widely used measure of market risk. It shows the market's expectation of 30-day volatility. The VIX is constructed using the implied volatilities of a wide range of S&P 500 index options.
There are risks associated with fixed-income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer term securities.
Past performance is not a guarantee of future results.
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