Markets danger zone: 5 things investors need to watch

Key measures that can reveal financial stress as conditions become less favorable.

  • By Robin Wigglesworth and Joe Rennison,
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As financial markets enter a more challenging phase, investors and analysts are looking for signs that can indicate financial stress. Here are some of the main contenders.

1. Vix: The champion of fear gauges

The Cboe Volatility index (.VIX) is the best-known fear indicator, so much so that it is dubbed the “fear index”. Although it was created in 1993, it rose to prominence during the dotcom bust and especially the financial crisis, when the media used it as a handy proxy for the level of panic on Wall Street. It is commonly known as Vix, after the unique ticker it is given by data providers.

Vix aims to measure the implied volatility of the US stock market over the next 30 days, derived from the prices of options called puts and calls. The index is structured so that if investors expect S&P 500 (.SPX) fluctuations to average 1 per cent a day for the next month, the Vix level is about 20 — roughly its long-run average.

At the height of the financial crisis the index rocketed to 89. In the February market fall that became known as “Vixmageddon” (after Vix-linked investment products collapsed and fuelled the sell-off) it touched an intraday peak above 50. It rose to just over 25 last month.

2. Skew: A challenger for the title

Like the Vix index, Cboe’s Skew Index (.SKEW) is based on the prices of options on the S&P 500 and is named after the curve of implied volatility that traders call skew. But Skew measures the difference between the cost of buying insurance against a market decline and the cost of buying the right to benefit from a rally.

It is therefore, in theory, a good measure for the amount of fear in the financial system. Skew typically ranges from 100 to 150, where a value of 100 means that the expected stock market gains is roughly normal. Much above that indicates investors are becoming more worried about market crashes than strong rallies.

In practice, Skew appears to be a poor measure of pure fear, and oscillated downwards during the financial crisis. In recent weeks the Skew rose above 120.

3 . Yield curve: Old champion still in the ring

The yield curve is the oldest contender on this list, and one with an admirably accurate record of forecasting economic recessions.

It is the name given to the slope made up of bond yields of various maturities. Normally, it costs less for countries to borrow for one year than five years, and less for five years than 10 years, and so on. So most of the time the yield curve slopes upwards. But when it “inverts” — when short-term bond yields are actually higher than longer-term ones — it has been typically presaged an economic recession.

Some economists think the yield curve inverting indicates that the Federal Reserve has raised interest rates too aggressively and a downturn is therefore coming, while others argue that an inverted curve causes a recession, by restricting credit growth. Regardless, the US yield curve has inverted ahead of every American economic downturn since the second war world, which is why many investors and analysts are eyeing the flattening with trepidation.

But some economists stress that the yield curve’s mojo might have faded with age , or might always have been exaggerated.

“It might be fair to interpret a large inversion in the same way you would have interpreted a small inversion in the past. But we are far from that today, and we don’t expect to see that in the coming years,” Jan Hatzius, chief economist at Goldman Sachs, said in a recent note.

4. Cross-currency basis: King Dollar’s favorite contender

Dollars are the lubricant that oils the global economic system, and spikes in demand for dollars can be a good sign of financial distress. One way of measuring this is through the “cross-currency basis”. Simplified, the basis is, in effect, the additional cost banks charge for swapping one currency for another in the derivatives market.

The dollar cross-currency basis can go haywire at times of turmoil, such as during the financial and eurozone crises, when banks and investors scramble to raise dollars to finance dollar-based liabilities.

The basis goes particularly wonky around the end of the financial year, when banks seek to reduce the amount of derivatives they hold on their balance sheets ahead of reporting requirements. This typically leads to a dramatic increase in the cross-currency basis of many foreign exchange swaps, and makes it poor measure of financial fear, argues Josh Younger, an interest rate derivatives strategist at JPMorgan.

However, outside of these reporting periods, when banks are more willing to do business, it can be a useful metric of appetite for dollars, and how stressed that demand is. And there was a sharp spike in the dollar cross-currency basis in late September, which analysts say made Treasuries less attractive to foreign investors, helping send yields higher and triggering the broader market reversal.

5. Financial conditions: The Frankenstein’s monster of fear gauges

Financial conditions indices may not be quite as scary as Dr Frankenstein’s famous creation, but much like Mary Shelley’s beast they are stitched together from a multitude of other parts — such as bond yields, currency movements and equity valuations.

The overall result is a benchmark that is designed to measure how stressed financial markets are, and to what extent they are supportive or restrictive for economic growth. They are typically designed to climb when markets are distressed and hamstring growth, and fall when markets are buoyant and nurture expansions.

The most famous measure is Goldman Sachs’ Financial Conditions index, by dint of its long record and the fact that it was originally designed by Bill Dudley, the former head of the New York Federal Reserve. But several investment banks now have their own variants, as do the Federal Reserves of St Louis, Chicago and Kansas City.

“Because movements in financial markets are a major factor influencing broader financial conditions, it is necessary to understand how financial market developments can affect the economic outlook and, therefore, the appropriate setting of monetary policy,” Mr Dudley said in a speech last year, before stepping down from the NY Fed.

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