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Improving Financial Market Conditions and Economic Recovery

After deteriorating sharply in August 2007 and then again in the fall of 2008, financial market conditions have improved markedly during the past quarter. Given the historical relationship between financial market conditions and economic activity, we interpret this as an encouraging sign that the economy may be recovering.

The improvement in financial markets can be observed in the recent evolution of a few indicators of financial market stress, including indicators of borrowers' credit risk, financial market liquidity, and uncertainty among market participants. We take a look at these indicators and explain how they may be related to economic activity.

First we consider two interest rate spreads, the Libor-OIS spread and the spread between the commercial paper rate and the T-bill rate. These spreads provide information about short-term credit risk as well as market liquidity.

The London Interbank Offered Rate (Libor) is the rate at which banks borrow dollar-denominated funds in the London interbank market, so it increases both with the short-term credit risk of the borrowing institutions and with the illiquidity of the Libor market. The Overnight Index Swap (OIS) rate, however, is the fixed rate swapped against the federal funds rate (the floating rate at which banks borrow overnight dollar-denominated funds in the federal funds market), so it reflects the market expectation of the rate that will prevail on average in a less risky and more liquid market. The Libor-OIS spread, therefore, is an indicator of both the short-term credit risk of financial institutions and the illiquidity of the Libor market relative to the federal funds market.

After increasing sharply during the summer of 2007 and peaking at 364 basis points in October 2008, the three-month Libor-OIS spread has steadily decreased. Recently, it returned to levels below 50 basis points. The spread's return to more typical levels suggests that both banks' credit risk and the relative liquidity of the Libor market have substantially improved.

Libor-OIS Spread

Spreads between the three-month commercial paper rate and the three-month T-bill rate tell a similar story: They increased sharply during the second half of 2007, peaked in October 2008, and have been decreasing since then to levels last seen before August 2007. This trend suggests that both the short-term credit risk of the issuing institutions and the liquidity of the commercial paper market relative to the T-bill market have improved.

Commercial PAper - Treasury Bill Spread

Like short-term credit spreads, longer-term credit spreads, such as the difference between corporate bond and Treasury security yields, have also declined, although to a much lesser extent. The current level of the spread between the yields of Baa-rated corporate bonds and 10-year constant maturity Treasury notes is slightly more than 4 percent, much less than its peak above 6 percent in December 2008, but still quite elevated.

Corporate Bond - Treasury Note Spread

To look at longer-term credit risk from another angle, we consider the five-year CDX North America Investment Grade Index (CDX NA IG), which is an index tracking the credit default swap (CDS) spreads for 125 North American investment-grade companies. The index can be interpreted as the average cost of buying CDS protection against the default of any of the underlying 125 companies: If the five-year index is 150, a market participant can buy five-year protection on all of the 125 companies by paying annually 150 basis points per company. The index therefore increases with the perceived risk of those companies defaulting.

The index sharply increased in March 2008 in conjunction with the collapse of Bear Stearns. It peaked at 279 basis points in December 2008, had a second peak at 262 basis points in March 2009, and then continuously decreased toward its current level below 150 basis points. The High Volatility Index, which tracks the subset of 30 companies with the widest CDS spreads, displayed the same qualitative behavior. The trends in both indexes indicate that the cost of buying insurance against default has decreased, and likely so has the risk of default, although the cost remains high relative to the past.

CDS Spread Indexes

The indicators we have looked at thus far are linked to firms' credit risk. We now turn to some indicators of consumers' credit risk. Some useful indicators are the spreads between the yields on asset-backed securities and those on risk-free, two-year Treasury notes. These spreads proxy for the credit risk of the corresponding underlying asset classes (like automobile loans or credit cards). After peaking in late 2008, these spreads have come down, signaling an improvement in the market's assessment of consumers' credit risk, although the spreads remain much higher than before the crisis.

Asset-Backed Security - Treasury Note Spreads

Finally, we turn our attention to an indicator of general market risk. The Chicago Board Options Exchange's Volatility Index (VIX) measures the implied volatility of the S&P 500 stock index over the next 30 days, using the stock index option prices. Numbers correspond to the annualized percentage point change expected over the next 30 days. The VIX index is considered to be a forward-looking indicator not only of market risk, but also of uncertainty and sentiment among market participants.

After reaching a historic high of 62.6 percent in November 2008, the index has rapidly fallen off toward its current level of 32 percent.

Volatility Index VIX

What does all this imply for economic activity? In the past, indicators of financial market stress have tended to be negatively correlated with economic activity. That is, on average, periods of financial market stress have tended to coincide with periods of weak economic activity. The table below shows correlations between some of these financial market indicators and indicators of economic activity (current and future GDP and investment).

The CDX is strongly correlated with GDP and investment, whereas the financial commercial paper spread shows little, if any, correlation. Also, notice how several indicators of financial market stress tend to be more strongly correlated with future economic activity, relative to current activity, suggesting that they tend to lead the cycle. The period after the second quarter of 2007 is somewhat anomalous because of the extreme values reached by some indicators of financial market stress. If one excludes that period, therefore, some correlations are affected. The main message, however, is not overturned.


GDP Investment
Same quarter Quarter +1 Quarter +4 Same quarter Quarter +1 Quarter +4
Three-month Libor-OIS spread -0.55 0.16 -0.50 -0.56 0.02 -0.52
Financial commercial paper spread -0.01 0.38 0.00 -0.06 0.30 -0.02
Baa corporate bond spread -0.55 -0.05 -0.31 -0.04 -0.19 -0.44
CDX NA IG index -0.78 -0.26 -0.81 -0.83 -0.42 -0.72
ABS credit card spread -0.57 -0.09 -0.64 -0.61 -0.15 -0.75
ABS home equity spread -0.50 -0.10 -0.74 -0.53 -0.15 -0.79
ABS auto spread -0.42 -0.02 -0.36 -0.44 -0.03 -0.46
Volatility index (VIX) -0.33 0.02 -0.15 -0.44 -0.08 -0.32
Note: Correlations were computed after detrending the logarithms of GDP and investment with an H-P filter.
Sources: Bloomberg; Merrill Lynch; Federal Reserve Board; Wall Street Journal; Financial Times.

There are several factors driving these correlations.

First of all, economic shocks can simultaneously affect both economic activity and financial market conditions. For instance, an adverse productivity shock, which causes productivity to be low for an extended period of time, tends to discourage current investment and increase default probabilities, credit risk spreads, and indicators of market illiquidity. Similarly, an adverse volatility shock that increases market risk and uncertainty for an extended period of time will have a similar effect on current investment, default probabilities, and indicators of financial market stress.

Moreover, economic activity and financial market conditions can affect each other directly, with the direction of causality running both ways. On one hand, shocks that depress economic activity tend to deteriorate borrowers' balance sheets and net worth, thereby increasing their probabilities of default and indicators of financial market stress. On the other hand, a financial shock that directly deteriorates borrowers' balance sheets and net worth, like a surprise housing or stock market decline, tends to increase default probabilities, credit risk spreads, and the cost of financing. These effects will depress borrowers' investment and consumption demand, and thus economic activity.

Because indicators of financial market stress are negatively correlated with economic activity, and in some cases they tend to lead it, the recent improvement of financial market conditions represents a hopeful sign that economic activity may be recovering.

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