As financial markets gyrate, the echoes of 2008 are hard to ignore. But how do investors recognize when a market downturn is spiralling into another market crisis? By keeping an eye on signposts of impending disaster. Despite the volatility of the past couple of months, many of these indicators are still far from panic mode.
The TED (Treasury/Eurodollar) spread reflects the gap between U.S. government three-month Treasury bills and the three-month London Interbank offered rate (LIBOR) – the global benchmark for short-term lending rates among banks. An elevated TED spread indicates there is a higher perceived risk of lending within the banking system.
The TED spread has more than doubled since the beginning of August, to more than 30 basis points, a 14-month high. However, the spread is still well below its mid-2010 high of 46.71, let alone the extremes of the 2008 financial crisis, when it topped 450 basis points amid a virtual freeze-up of interbank lending. In fact, the TED spread was north of 75 basis points for more than a year before the 2008 crisis hit.
Check the spread
Some evidence of heightened stresses in Europe can be found in credit default swap (CDS) spreads. CDSs are essentially insurance products that protect a buyer of debt against the possibility that an issuer will default on its obligations. The "spread" is the annual cost of the insurance, expressed as a percentage of the amount of debt being insured. (For example, if a CDS carries a spread of 1 per cent, it would cost $100,000 a year to insure a $10-million debt.)
A spike in CDS spreads, when they involve governments and financial institutions, indicates there is growing risk of the kind of sovereign or bank default that could seriously disrupt the global financial system. And in Europe, the picture is getting ugly: Both bank and sovereign CDS spread indexes reached record levels this week.
The junk yard
This was another indicator that soared alarmingly during the 2008 credit crisis – the gap between the interest rate on 10-year U.S. government bonds and high-yield or "junk" bonds, the riskier end of the corporate bond spectrum. Spreads topped 20 percentage points at the height of the crisis, stark evidence of a panic in the credit market.
The spread between the Merrill Lynch High Yield Corporate Composite index and 10-year Treasuries topped 6.5 percentage points this week, its highest level in nearly two years, up more than 2 percentage points since late July. While that's still nowhere near the crisis levels, the sharp rise may nevertheless indicate the growing pressures that are weighing on financial markets, said Ed Yardeni, president and chief investment strategist of Yardeni Research Inc.
"This spread is an excellent leading economic indicator, and suggests that the [economic]outlook is deteriorating," he wrote in a note to clients this week.
The indicator of choice for stock-market stress is the Chicago Board Options Exchange Volatility Index, commonly known as the VIX . It measures the volatility expected in the U.S. stock market over the next 30 days, based on the trading of S&P 500 options . Other markets have similar volatility indicators, such as Europe's VStoxx and Canada's VIXC.
In theory, the VIX indicates only how confident investors are about the stability of prices. It doesn't differentiate between the likelihood of a downswing or an upswing in the market. In practice, however, elevated VIX readings signal rising uncertainty and perceived risks, which prompt many investors to move money to the sidelines for safety.
The VIX surged to nearly 50 last month, a two-and-a-half-year high, but has since pulled back into the mid-30s – still historically high, but nothing like the crisis peaks above 80. But the spread between the VIX and the VStoxx widened this week to its biggest gap since the Lehman Brothers collapse of October, 2008, as the VStoxx hit a 32-month high – evidence of the seriousness of Europe's deteriorating sovereign-debt situation.
The Federal Reserve Bank of St. Louis created the St. Louis Financial Stress Index (STLFSI) two years ago in an attempt to better capture an overall impression of stresses in the financial system by combining a wide variety of indicators. The STLFSI uses 18 components and is issued weekly, to track changes in the overall stress levels in financial markets in a timely manner. The TED spread, long-term corporate bond spreads and the VIX are all among its components.
The STLFSI, which is calculated back to 1993 using historical data, has moved sharply higher since early July, rising from benign readings to approach two-year highs. Nevertheless, this broad stress indicator is only a fraction of its late-2008 peaks, and remains within its long-term historical range.