What the 'fear gauge' is saying about the markets
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Associate Editor
David Stevenson May 21, 2010
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You know banks are getting fretful when they don't want to lend money to each other. That's because they're worried that they won't get all of it back when they need it. So they put up the price. In the autumn of 2008, when Lehmans was going bust, real panic set in among the bankers. Money-market interest rates – measured by Libor (the London inter-bank offered rate) – soared. But over the last 18 months, money markets have steadily thawed out. Until last week, that is.
"Money markets tensions rose yesterday," said last Friday's FT, "amid rising nervousness over the €750bn [eurozone] rescue package, as the rate banks pay for loans hit nine-month peaks because of concerns over counterparty risk". That's the fear that those on the other side of the trade won't be able to settle it.
So just how much financial stress has built up in the system?
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A good way to assess it is to keep an eye on the HSBC Financial Clog Index. This is made of four equally weighted parts, so it ticks all the boxes.
First there are the inter-bank stress tests. One's the TED spread, the gap between rates on inter-bank loans (seen as riskier) and on short-term US government bills (seen as safe). The other is the Libor-OIS spread. Here Libor is seen as the riskier, while overnight index swap rates (OIS, which are based on Fed fund rates) are seen as safe. The wider these spreads go, the more fear there is out there. Then there's a gauge of financial institution default risk, as measured by credit default swaps (CDS). Again, this sounds heavy-duty. But in essence, CDSs are insurance that investors can buy if they fear a firm may be going bad. The higher a CDS price, the more risk there is.
Next up, we have mortgage agency credit spreads – these are barometers of how many US home loan borrowers might potentially default. Finally, there's stockmarket 'implied volatility', as indicated by the US VIX index. Implied volatility is the chance of shares rising or falling from a given level – it's based on what it costs for traders to insure themselves against big moves in the market. The VIX is known as Wall Street's 'fear gauge' because, broadly speaking, the higher it climbs, the more worried investors are becoming.It may all sound terribly technical, but the bottom line is that it tells you how rapidly risk aversion is rising. And you don't need to be a credit analyst to see what happened earlier this month. The chart opposite shows that the Clog index hit its highest point since last November, with rather a sharp spike occurring in the past month.
Now, you can also see that compared with October 2008, this index still suggests overall risk levels are in the relative foothills. But maybe this picture doesn't yet tell the whole story.
New York University professor and author Nassim Taleb made his name by predicting the credit crunch. He reckons that the world's debt problem is actually worse now than it was then. That's because governments have failed to learn the lessons, he tells Bloomberg. "We've had a couple of years since the meltdown – now the risks have increased and taken a much more vicious form".
What's more, Taleb warns that, in time, the next stage of the debt crisis could be sparked by a failed US Treasury auction. For instance, the US suddenly being unable to find enough lenders to fund its surging deficit. In other words, even the supposedly risk-free investments could go sour. If he's right, the Clog Index could soon be heading right back up the chart.
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