“Financial Stress” in the Credit Markets v. the 2-Year Yield

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by Wolf Richter, Wolf Street:

The two-year yield, now surging, is a leading indicator.

The Financial Stress Index, released weekly by the St. Louis Fed, is designed to track financial conditions that companies face in the markets. It reached record lows in November – meaning that there was extraordinarily little “financial stress” in the markets after years of ultra-easy monetary policies. The index then ticked up a little and did a mini-spike in February, but was still far below the historical “normal.” Then it zigzagged higher. Last week it had risen to the highest level since the Oil Bust two years ago, though it remained way below historical “normal.” In the current release, the index backed off again.

The index is designed to show a level of zero for “normal” financial conditions (blue line). When financial conditions are tighter than normal, the index shows a positive value. When these conditions are easier than normal, the index is negative. Note the recent rise (circled):

After years of ultra-loose monetary policies, financial conditions in the US economy have been dominated by risk-blind investors chasing any kind of yield, which resulted in minuscule risk premiums for investors, ultra-low borrowing costs even for junk-rated companies, and immensely inflated asset prices.

Even the Oil Bust and the Taper Tantrum, while they increased financial stress somewhat, couldn’t push financial conditions back to “normal” levels, given the Fed’s stimulus at the time. The chart also shows just how long the easy-money conditions have endured since the Financial Crisis, with the Financial Stress Index below “normal” since late 2009.

So now there’s also some response in the market to the removal of accommodation by the Fed, but it isn’t much. The response hasn’t even reached the level of the Taper Tantrum, when the Fed had suggested it might eventually “taper” away what had been called “QE Infinity.” Now at -0.97, the index remains solidly below “normal.”

The index, made up of 18 components – seven interest rate measures, six yield spreads, and five other indices – takes a broad measure of how markets perceive and price risk. And currently, the markets are still somnolent.

By “normalizing” its monetary policies, the Fed effectively attempts to tighten financial conditions in the markets to bring them back to historical norms: raise yields, widen spreads, increase risk premiums, etc. – in other words, make credit more expensive and harder to come by, and increase the price of risk.

But the market is slow to react to a shift in monetary policies. And when it does begins to react, the adjustments can be eye-popping.

The Financial Stress Index and the two-year Treasury yield move roughly in parallel, but with a large time lag. The two-year yield is very responsive to changes in monetary policy and tends to overshoot late in the rate-hike cycle. This makes it a leading indicator by years as to where many of the financial stress components will go: junk bond yields, spreads, risk premiums, and the like. They will follow – but way behind.

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