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Financial Conditions at Crisis Level

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According to Federal Reserve Governor Lael Brainard, tightening financial conditions in the U.S. over the past eighteen months have realized the equivalent of three quarter-percentage-point interest-rate hikes (i.e. 75 basis points). Other economists have also suggested monetary conditions have tightened since the Quantitative Easing programs tapered and ended in 2013 and 2014, respectively, and the Federal Reserve increased the federal funds (interest) rate in 2015. This could all just be conjecture though.  

To move beyond conjecture, there needs to be a reliable and comprehensive way to measure financial conditions. In fact, there is and it comes from the Federal Reserve Bank of Cleveland.

The Cleveland Financial Stress Index (“CFSI”) was designed as a coincident indicator that tracks systemic stress in the U.S. financial system on a continuous basis. High values, as measured by standardized differences from the mean (i.e. z-scores or standard deviations), indicate high systemic financial stress.

Cleveland-Financial-Stress-Index_2016-03The CFSI combines sixteen measures of conditions in six major types of financial markets: 1) credit, 2) equity, 3) foreign exchange, 4) interbank, 5) real estate, and 6) securitization. Measures of systemic stress in all six markets have in recent months risen and, in some cases, spiked to precarious levels. If you click on the accompanying graph of the CFSI, then you will see that it rose to as high as 1.92 last month (February 2016).

Is that high?

It sure it. As mentioned earlier, the CFSI provides a continuous measure of stress. To interpret the continuum, it is divided into four levels or grades. The grade thresholds are dynamic and move slowly over time. The highest grade, which signifies significant stress, currently starts at 1.855. Hence, the CFSI score of 1.92 in February 2016 puts it in the highest grade and marks a time of significant U.S. financial stress.

How does this compare to other periods?

Given the 25-years’ worth of CFSI data, the 1.92 score in February 2016 puts it not only in the highest grade but also in the 96th percentile. Looking back at the graph, the rare times it has increased to such a precarious level occurred in: 1) October 1998, when the Asian and Russian Financial Crises were at their height, 2) November 2007, when the Subprime Mortgage Crisis began, 3) few times in 2008 at the beginning and height of the Global Financial Crisis, and 4) August 2011, when the European Debt Crisis rocked the Eurozone.

In other words, it would appear that U.S. financial conditions are at a crisis level. Whether or not you believe an actual crisis is in the horizon, please consult an investment fiduciary before making any investment decisions.

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