St. Louis Fed’s Financial Stress Index

When I started this blog, I added what sounded like a whimsical tagline at the time, “Your one stop VIX-centric view of the universe.” In retrospect, perhaps the joke was on me, as the content here has consistently been VIX-centric, despite my occasional forays into that “and More” netherworld.
I will be the first to admit, however, that the VIX captures only a small slice of investor sentiment and represents only one type of threat to the markets.

Back in March 2007 I addressed a broader range of sentiment indicators when I wrote A Sentiment Primer (Long) and urged investors to take a broad-based view of threats to the market in The Credit Default Swap Canary. Along the way, I have been a strong proponent of using put to call ratios (Put to Call Everest), bond yields, the VIX divided by T- bill yields (VIX:IRX), the TED spread, counterparty risk measures, and other factors.

One excellent index which attempts to capture a broad range of components of financial stress is the St. Louis Fed’s Financial Stress Index, henceforth to be known here as the STLFSI. The index constituents are highlighted below and include an interest rate group, a yield spread group and an third uncategorized group of additional indicators in which the VIX is one of five components.

Interest Rates:

• Effective federal funds rate
• 2-year Treasury
• 10-year Treasury
• 30-year Treasury
• Baa-rated corporate
• Merrill Lynch High-Yield Corporate Master II Index
• Merrill Lynch Asset-Backed Master BBB-rated

Yield Spreads:

• Yield curve: 10-year Treasury minus 3-month Treasury
• Corporate Baa-rated bond minus 10-year Treasury
• Merrill Lynch High-Yield Corporate Master II Index minus 10-year Treasury
• 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

Other Indicators:

• J.P. Morgan Emerging Markets Bond Index Plus
• Chicago Board Options Exchange Market Volatility Index (VIX)
• Merrill Lynch Bond Market Volatility Index (1-month)
• 10-year nominal Treasury yield minus 10-year Treasury Inflation Protected Security yield (breakeven inflation rate)
• Vanguard Financials Exchange-Traded Fund (VFH)

The chart below shows the performance of the STLFSI and the VIX going back to 1993. Not surprisingly, there is a high degree of correlation. If one accepts the STLFSI as a more broad measurement of stress in the financial system, one can make a case that while the VIX is usually directionally correct, at certain times the VIX has underestimated the stress in the system (e.g., May 2008) while at other times the VIX has overestimated the stress in the system (e.g., May 2010). Going forward, I will make an effort to flag important divergences between the VIX and the STLFSI.

Note that the Kansas City Fed has a similar Financial Stress Index, aka the KCSFI, which is more concise and more focused on yield spreads.

The St. Louis Fed has more information on the STLFSI here, while the Kansas City Fed has more information on the KCSFI here.

Related posts:

• Revisiting the Flight-to-Safety Trade
• Chart of the Week: The Flight-to-Safety Trade
• The Credit Default Swap Canary
• A Sentiment Primer (Long)
• Chart of the Week: Record Low Yields for the 2-Year U.S. Treasury Note
• Chart of the Week: 10-Year Treasury Note Yield
• Chart of the Week: Ratio of VIX to Yield on 3 Month T-Bills

[source: Federal Reserve Bank of St. Louis]

Disclosure(s): none

Chart of the Week: Ratio of VIX to Yield on 3 Month T-Bills

I have been mulling over some ideas for new features on the blog (feel free to suggest some possibilities in the comments below) and one of these is a chart of the week that highlights what I think is a particularly salient development from the past week. This week, of course, there are many possibilities to draw upon, given some of the historic market activity. Friday’s Citigroup implied volatility chart is one such example.

This week, however, I would like to highlight the T-Bill aspect of the recent flight to safety with a ratio of the VIX to the 3 month T-bill yield. A chart of the VIX:IRX ratio is below.

Some readers may recall that following the Lehman Brothers bankruptcy in mid-September I highlighted this same ratio in a chart going all the way back to 1990 in Volatility Catastrophe Graphic. At that time, the VIX:IRX ratio had just exceeded 100, shattering the all-time high set in March when the ratio jumped to 5.3 on the heels of the Bear Stearns failure. This week the ratio took another quantum leap, surpassing 1600 at one point and closing at 726.

When it comes to measuring fear, VIX is only part of the story. The VIX:IRX ratio paints a much broader – and darker – picture of fear and the flight to safety.

[source: StockCharts]

Volatility Catastrophe Graphic

Catastrophe may not be exactly the right word here, but I needed a title with which to introduce the graphic below, which is a ratio of the VIX to the 3 month T-bill yield (VIX:IRX ratio).

The chart goes back to beginning of the VIX data in 1990 and even in a log scale demonstrates that the current environment is several orders of magnitude more concerning (at least from a volatility and flight to safety perspective) than any other day in the last 19 years.

For more background on this particular ratio, check out Expanding on the VIX and the 10 Year Treasury Note Yield and Fear and the Flight to Safety.

[source: StockCharts]

Expanding on the VIX and the 10 Year Treasury Note Yield

On Friday, in Fear and the Flight to Safety, I posted a chart of the ratio of the VIX to the 10 year Treasury Note yield. That post triggered a number of interesting responses, two of which I would like to highlight here.

First, Jason Goepfert of SentimenTrader.com, noted in a Minyanville.com article titled Cashing in on the Panic that past instances in which volatility spiked to extreme levels relative to the 10 Year Treasury Note offered superb buying opportunities. Goepfert examined returns from five days to three months from the spike and found “results going forward were exceptionally positive and consistently so.” See his table of results for additional details.

Second, Tom Drake of Putting the Pieces Together suggested an obvious enhancement to the ratio chart: substituting the 3 month Treasury Bill yield for the 10 Year Treasury Note, on the grounds that the flight to safety usually favors short-term government debt. A monthly chart of the VIX to 3 month T-bill yield ratio (VIX:IRX), which is similar in many respects to Friday’s chart, is as follows: