Financial Market EKG Update
January 6, 2009
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Steady, Steady
Financial indicators, having improved, are holding
Interbank lending spreads (TED Spread) have been dropping for a month, and indeed, they are now in the range they were in June through September of 2008, just before the onset of the financial crisis in mid-September. Investor confidence (VIX) continues to improve, also returning to pre-crisis levels. The LIBOR-OIS spread has narrowed sharply, returning to February 2008 levels. In general, all three of our financial indicators show signs of improvement, although they are still far from their historical norms.
Gasoline prices at the pump are creeping upward in tandem with the recent rise in crude oil prices, attributable to military actions in the Middle East and the threat of production cuts by OPEC.
Our initial observations for this series of commentaries about financial market health (based on our readings of October 13) can be read below.
We recently added two more indicators of economic health: crude oil futures and the price of a gallon of regular unleaded gasoline. While not specifically financial market indicators, they nevertheless have an impact on overall economic well-being.
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TED Spread: Last 30 days
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VIX: Last 30 days
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LIBOR-OIS Spread: Last 30 days
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Crude Oil Futures: Last 30 days
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Regular Unleaded Gasoline: Last 30 days
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October 13, 2008
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Financial Market Electrocardiograms
The financial market crisis of 2008 has brought forth an historic response from governments around the world.
This coordinated exercise of political will has a high likelihood of being effective in arresting the downward spiral of confidence that has been reflected, first, in a virtual paralysis of trading in many interbank funding markets and, second, in a plunge in prices in those markets – such as for equities and commodities – that have been able to trade.
Recent readings for the TED and LIBOR-OIS spreads have been “off the charts” in an almost literal sense: they have been, respectively, 3.8 and 5.9 standard deviations from the mean of the past twelve months, both of which far exceed the expected range for 99% of all statistical observations. The significance of this divergence from historical experience cannot be overstated. The recent VIX reading exceeds the high anxiety marks achieved in the 1998 Russia/Long-Term Capital Management and 2002 tech stock crash. The VXN rivals its reading of late September 2001. In the recent 60-70% range, they are over three times the expected historical average – and are clearly unsustainable.
In sum, it is not hyperbole to describe the current crisis as an economic heart attack. Heart attacks can be survived and patients can and do go on to lead long and healthy lives. In this case, the extraordinary initiatives taken by monetary, fiscal, regulatory, and legal authorities around the world to respond to the dangers of this financial seizure go a long way toward insuring the survival of the patient, the global capitalist market system. It is too soon to speculate in any useful detail about the therapies that will be needed to bring about a less risky, i.e., healthier, set of rules and behaviors for financial markets, but almost surely these will follow in train once the critical emergency is past.
We should be able to see progress toward a greater degree of sound fundamental health for global financial markets in their electrocardiogram readings in such measures as VIX and TED and other market measures of spreads and expected volatilities.
Several indicators of the degree of dislocation in money and credit markets have garnered close attention as investors and others monitor the progress of this worldwide market calamity and the historic official efforts to address it. Among them:
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The TED Spread
"TED" refers to the spread between market rates on U.S. Treasury instruments and those for interbank loans as measured by LIBOR (the London InterBank Offered Rate). The spread, or difference, between these two rates is commonly interpreted as a measure of the degree of perceived credit risk in interbank markets and in the economy more generally. Lending among commercial banks involves some (usually minor) credit exposure while short-term Treasury securities are virtually risk-free. The spread between the two instruments indicates the incremental yield that market participants demand in order to accept the incremental risk involved in bank credit.
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LIBOR-OIS Spread
The LIBOR-OIS Spread is another carefully watched indicator of credit stress. It measures LIBOR against the Overnight Index Swap rate, which is in effect an expectation for the near-term future Federal funds rate. Like the TED spread, it measures the difference between a risky and a risk-free rate.
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VIX
The VIX is the Chicago Board Options Exchange (CBOE) Volatility Index. It is a mathematical implication of the expected future volatility of the S&P 500 Index, as derived from the market-clearing prices of put and call options. It is commonly interpreted as a measure of market uncertainty about the forward outlook.
It might also be thought of in insurance terms, as a market process for setting premium levels. Options sellers agree, in consideration for a premium, to buy (in the case of put option sellers) or sell (for call option sellers) equities or indexes for a specific future term at a specific fixed, or strike, price. The option buyer, in paying the premium, is relieved of the uncertainty about the price that might be available over a defined future period. When market uncertainty is high, options buyers will be eager to transact and option sellers will be reluctant, so higher premiums – higher readings on the VIX – will be required to clear these options markets. VIX is an indicator of the degree of investor uncertainty.
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This review has been prepared by ING Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. The material presented is compiled from sources thought to be reliable, but accuracy and completeness cannot be guaranteed. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management's current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities.
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