Less Steep Treasury Yield Curve And Declining Financial Stress Index

The Treasury Yield curve is normal but it was steeper three-month ago than now. So the expectation of future inflations are falling and not rising. Over the one month period (not shown in the attached graph), the curve has not changed much. A flattening curve could also happen in anticipation of slower economic growth and when the short-term rates rise on the expectations that the Fed will raise the rates.

In early 2010, the St. Louis Federal Reserve created a Financial Stress Index, which includes 18 weekly data series to measure the financial stress in the market. Some of the “stress” top measure that St. Louis Fed mentions are:

• An interest rate spread, such as the difference between yields on a “risky” asset (such as corporate bonds) and a “risk-free” asset (such as U.S. Treasuries), may be used to measure default risk.
• Whether financial institutions are able to secure funding to finance short-term liabilities may indicate liquidity risk.

The index has a higher frequency and, hence, has greater volatility and noise. It is constructed using seven interest rate series (Fed Fund rate, 2-year etc.), six yield spreads (10-year/3-month etc.) and five other indicators ($VIX, S&P 500 Financial Index, Emerging Market Bond Index etc.). It goes back to 1993.

The average value of the index is designed to be zero, which means no-stress. Values below zero suggest below-average financial market stress and values above zero suggest above-average financial market stress.

In July 2014, it had reached a record low and on October 2008 it had reached the record high. The Financial Market Stress declined last week.

Over the past week, 13 of the 18 indicators contributed negatively to the change in the STLFSI, five more than the previous week. The largest negative contribution came from the Merrill Lynch Bond Market Volatility Index (Mlynch_BMVI_1mo), followed closely by the expected inflation rate over the next 10 years (BIR_10yr) and the yield on corporate Baa-rated bonds (BAA). Five of the 18 indicators contributed positively to the weekly change, the same number as the previous week. The largest positive contribution was made by the Chicago Board Options Exchange Market Volatility Index (VIX), which measures equity market volatility.

Over the past year, 10 of the 18 indicators have made a positive contribution to the index and eight indicators have made a negative contribution, the same numbers as the previous three weeks. Once again, the largest positive contribution over the past year came from the BIR_10yr and the largest negative contribution came from the BAA.