The Foreign Exchange Matrix. Barbara Rockefeller

Management in September 1998, and then peaked in October 1999 ahead of Y2K.

      Figure 2.4 – Kansas City Fed Stress Index (monthly)

      Source: research.stlouisfed.org/fred2

      In 2000, the KCFSI peaked twice, first in line with the bursting of the technology bubble and subsequent sharp NASDAQ Composite decline and then again later in the year. “The second peak was December 2000, when there were no obvious reasons for increased financial stress other than the approach of recession. The next peak came after the 9/11 attacks and the most recent peak came in October 2002, amidst widespread accounting scandals (Enron/World Com).

      During the subprime crisis, the KCFSI has spiked on a few occasions, first in response to mortgage-related concerns in August and November 2007, and then again in March 2008, when Bear Stearns collapsed. Later in July 2008, the index again spiked when IndyMac failed and Fannie Mae and Freddie Mac had their issues. The following year saw the largest spikes seen ever in the index, first in September 2008, following the Lehman Brothers bankruptcy, AIG bailout, and forced merger of some institutions (such as Bank of America and Merrill Lynch). The index spiked again in October 2008 amidst debate about the $700 billion Troubled Asset Relief Program (TARP).

      To give a sense of magnitude of the moves, the Kansas City Financial Stress Index peaked at 5.57 in October 2008 (after Lehman Brothers bankruptcy and around the TARP debate) and remained elevated (at 4.68) at year-end. In the first quarter of 2009, despite wider deleveraging of positions in equities and commodities, the index edged lower (3.99 in March). By August 2009, the KCFSI had dipped below 1.0 and has remained below there ever since, even slipping into negative territory on several occasions in 2010, 2011 and 2012.

      St. Louis Federal Reserve Financial Stress Index (STLFSI)

      The St. Louis Federal Reserve’s Financial Stress Index (STLFSI) is similar to the KCFSI, but with 18 variables. It is updated weekly on a Thursday at 10 am Central Standard Time. ^[7] The STLFSI takes into account interest rates (the effective fed funds rate and two, ten, and 30-year Treasury yields, Baa-rate corporate yields, Merrill Lynch High-yield Corporate Master II index, Merrill Lynch Asset-Backed Master BBB rated rates), yield spreads 10-year Treasury minus 3-month Treasury yield curve, Corporate Baa-rated bond minus 10-year Treasury, Merrill Lynch High Yield Corporate Master II index minus 10-year Treasuries, 3-month London Interbank Offering Rate-Overnight Index Swap (LIBOR-OIS) spread, 3-month Treasury-Eurodollar (TED) spread, 3-month commercial paper minus 3-month Treasury bill, and other indicators including the JP Morgan Emerging Markets Bond Index Plus, the CBOE’s volatility index VIX, Merrill Lynch Bond Market Volatility Index (1-month), 10-year nominal Treasury minus 10-year Treasury Inflation Protected Security (TIPS) yield or breakeven inflation, and S&P 500 Financial Index (equities).

      The STLFSI peaked at 5.572 in the week ending 17 October 2008, a month after the Lehman bankruptcy, and closed the year at 4.596, which was still an elevated level when compared to the 0.676 reading seen the week of 4 January 2008. The index proceeded to edge lower into the first quarter of 2009, despite the near panicked deleveraging going on that sent the S&P 500 to a twelve-and-a-half year low of 667. By September 2009, the STLFSI was back under 1.0 and the index ended the year at 0.254, even with the admission by Greece that its books had been cooked. In 2010 and into early 2011, the index traded in negative territory at times and at worst edged up but never managed to break over 1.0. Even as euro zone peripheral tensions and US fiscal concerns increased in the summer of 2011, the STLFSI saw only the smallest of moves higher, topping out just over 1.0 on two occasions only in the weeks of 30 September and 7 October 2011. The STLFSI subsequently has remained below 1.0.

      Cleveland Federal Reserve Financial Stress Index (CFSI)

      In March 2012, the Cleveland Federal Reserve announced the creation of its own monthly financial stress index, which looks at 11 variables that are slightly different to those measured by the other Fed indexes. The CFSI is constructed using daily data from components that reflect credit, equity, foreign exchange and interbank markets. The Cleveland Fed offers four grades of stress:

       Grade 1: below normal stress with the index in a range of less than or equal to -0.50

       Grade 2: normal stress with the index in a range of -0.50 to 0.59

       Grade 3: moderate stress with the index in a range of between 0.59; and 1.68

       Grade 4: significant stress, with the index above 1.68

      In the fall of 1998, at the peak of the Long-Term Capital Management crisis, the CFSI “neared a value of 2.0,” a level that was not seen again until the start of the subprime mortgage crisis. The Cleveland Fed noted that the CFSI “climbed into the ‘significant stress period’ grade in late 2007 and remained there throughout the middle of 2009.”

      While the CFSI has not moved back into this ‘significant stress period’, it rose throughout 2011 and remained in ‘moderate stress’ territory in early 2012 before falling into ‘normal stress’ mode later in the year.

      4. Bank stress indexes

      Various banks have developed their own versions of the Federal Reserve stress indexes, which like the Fed stress indexes are popular tools for FX traders.

      Goldman Sachs Financial Stress Index (GSFSI)

      Global banking powerhouse Goldman Sachs has had its Financial Stress Index (GSFSI) in place since the collapse of Lehman Brothers in September 2008.

      “Goldman’s FSI consists of four equally weighted variables: the spread between the London interbank offered rate (LIBOR) and the overnight index swap (that is, the spread between the bank funding rate and the market’s perception of future official rates); the spread between the United States government’s repo rate (the discounted rate at which a central bank repurchases government securities from commercial banks to manage the level of money supply) and the mortgage repo rate; the amount of commercial paper issuance; and the ratio of money market funds to the value of equity market capitalisation in the US, a measure of risk aversion,” explains Jim O’Neill, former head of global economic research at Goldman Sachs, now Chairman at Goldman Sachs Asset Management.

      BofA/Merrill Lynch Global Financial Stress Index

      In November 2010, BofA/Merrill Lynch Global launched its own Global Financial Stress Index. Their GFSI is touted as “a comprehensive, cross market gauge of risk, hedging demand and investment flows.” BofA/Merrill’s goal is to “to help investors identify market risks earlier and more accurately than commonly used risk indicators, such as the VIX index.” In the launch statement for the index in November 2010, BofA/Merrill said:

      “The GFSI composite index aggregates over 20 measures of stress across five asset classes and various geographies, measuring three separate kinds of financial market stress: risk, as indicated by cross-asset measures of volatility, solvency and liquidity; hedging demand, implied by the skew of equity and currency options; and investor appetite for risk, as measured by trading volumes as well as flows in and out of equities, high-yield bonds and money markets.”

      The statement noted that “back-testing of the GFSI since 2000 illustrates that sharp rises in the index over short periods of time would have had a high degree of accuracy in forecasting sell-offs in assets, particularly global equities, commodities and US high-yield bonds.”

      “Since the global financial crisis, risk appears to have become as important to investors as return,” said Michael Hartnett, chief Global Equity strategist at BofA Merrill Lynch Global Research. “The GFSI measures risks not normally visible in public markets by incorporating assets trading in the over-the-counter market. We believe its breadth and depth make it a better measure of financial market stress than the VIX, which is based on US options data alone.”