Unpleasant Facts and Other Musings

A lot of the basic market indicators have been flashing panic signs recently. One example of this panic is the VIX, a measure of expected S&P 500 volatility over the next month, has spiked up from just over 15 to over 35 today (It hit 45 last week) in a little over a month. When the VIX is purified for recent price action in the S&P 500, the recent volatility spike suggests that people should be buying the market. However, there is increasing pressure in the financial system and buying against a panicky market while the financial system’s pressure is accelerating can be very risky.  

There are a few measures that can be used to measure financial system pressure. Equity prices and volatility, the former going down and the latter going up, are one sign. Another is credit default swaps (CDS). CDS for the average major American banks rose between 50 to 100 basis points over the past month.  A less volatile measure of market stability is the LIBOR-OIS spread. This is the spread between the rate banks lend to each other on the interbank market and the effective federal funds rate. Not only does this spread indicate stress, but according to research published by the St. Louis Fed “the LIBOR-OIS spread has been the summary indicator showing the “illiquidity waves” that severely impaired money markets in 2007 and 2008.” This time the illiquidity stress is coming from European banks exposed to sovereign risk, as well as other financial institutions that are exposed to distressed European banks (The flight to quality towards Switzerland banks caused short term interest rates there to briefly go negative, hitting -0.25% on May 25^th). 

The chart bellow shows the LIBOR-OIS, which fell through most of 2009, has rose over 20 basis points in the past month.