source: this blog
source: this blog

As you may know, I have been writing Rolling Alpha posts for over 2 years now – meaning that I have spent a lot of time trawling through Forbes, Quartz, the Business Insider, Bloomberg and Reddit in search of inspiration. In that time, I have noticed that there is a certain regularity to the appearance of articles declaring that the next great crisis is nigh upon us, and the end of the world, et cetera.

Personally, I suspect that this has a lot to do with wanting to say “I told you so” after the fact, and so attain fame and fortune for being the guy that called it, and then become John Paulson with a giant hedge fund, and have a book written about you by Michael Lewis.

It’s why I too periodically dip a toe into the ocean of prediction (I somewhat shamefully recall this post: America’s Hyperinflation*).
*although I still maintain that it’s a possibility, and that the US will remain quite vulnerable until economic growth catches up with the volume of liquidity floating around.

But the big call at the moment is coming on the basis of this graph:

Screen Shot 2014-06-26 at 7.00.28 AM

This is the St Louis Fed Financial Stress index (I’m going to call it the financial stress index). It’s meant to indicate just how concerned people/investors are about the economy. So when this journalist (Jesse Columbo) takes a look at it, what he sees is:

  • The financial stress index is a measure of investor panic.
  • It went negative between 2004 and 2007 – meaning that people during the housing bubble were less than stressed about their finances.
  • In fact, let’s use the adjective “buoyant”.
  • Then 2007 happened, and people panicked off the hook.
  • But then everything calmed down, and now we’re back to pre-crisis buoyancy levels.
  • Last time, that meant there was a bubble.
  • Ergo: this time, there is another bubble.
  • Hashtag panic. Hashtag the end of the world is nigh.

So I went and had a look at what the financial stress index actually is. The summary:

  1. The St Louis Fed took some interest rates and some other indices.
  2. It combined them together into one number.
  3. They made the number that that they got in late 1993 equal to zero.
  4. They then made all the other numbers relative to that 1993 number, so that you get the index varying around zero.
  5. Meaning that if the index is above zero, then the markets are feeling more panicked than they were in late 1993.
  6. And if the index is below zero, then the markets are feeling less panicked than they were in late 1993.
  7. But that’s fine, because in late 1993, the markets were doing nothing interesting, so that’s a fair approximation for “normal”.

I mean, in 1993, we didn’t have the internet or cellphones. The face of finance has fundamentally changed.

But let’s just assume that we happily accept that the financial stress index is a good measure of the waves of greed and fear that periodically swing the market.

The next question becomes “are there any other explanations for the change in the index?”

So to be clear, the index is made up of:

  • interest rates on US government bonds (of differing durations/lengths of time to maturity)
  • some indices that track the yields (interest rates) being returned on investment-grade Asset-Backed Securities (like mortgage-backed securities).
  • some yield spreads (being the difference between the interest rates on certain key bond indices and the interest rates on those US government bonds already included – which is a measure of the risk attached to those bond classes in general)
  • the Chicago Board Options Exchange Market Volatility Index (AKA the VIX).

If you just glossed through that list, then all you need to know is that the main reason for a movement in the financial stress index is a movement in interest rates.

What has been happening to interest rates for the last few years?

The central banks of the world (and the Fed in particular) have been:

  1. keeping the base interest rates near zero; and
  2. directly intervening in the bond and asset-backed security markets by buying up those assets in massive dollops each month in order to steadily inject liquidity into the economy.

Those stress levels aren’t low because people feel confident.

Those stress levels are low because a bunch of central bankers are attempting to persuade people that they ought to feel more confident.

Is this resulting in some bubbles? Almost certainly. But that’s by design: it’s not a measure of complacency.

Although, I guess, that’s not really a cause for comfort.

Next week: the VIX.