The public policy blog of the American Enterprise Institute

Subscribe to the blog

Discussion: (28 comments)

  1. Mark,

    Please help me understand the value of this index beyond a graphic representation of the painfully obvious.

    It’s not predictive (it was at it the lowest point just before the markets were thrown into a tizzy in the last four days of June 2007 and its very lowest point was just before the the first hint of subprime troubles in February of 2007). As the housing bubble was inflating, the index was steadily super low with no indication of any stress; none even after housing prices began to tumble in in 2006, leading to the crisis of 2008. That the world is not worried at the moment doesn’t seem like terribly valuable information, particularly if there is, in fact, something to worry about.

    1. morganovich

      to amplify methink’s point, even if we were to accept that this index once held predictive power (itself a highly suspect proposition) what would lead you to believe that it would now?

      this model is based on interest rates and yield spreads. those are being deliberately manipulated by the fed to a degree unprecedented in US history.

      even if such rates and spreads once organically produced a signal that possessed predictive power, they are now showing somehting different: the effects of manipulation.

      to claim that they provide the same signal that they used to seems like cargo cult thinking.

      if rates are held in place by the fed as opposed to be able to move based on market forces, they tell us nothing.

      it’s like gluing your speedometer needle to zero and then driving around claiming you are not moving.

      1. Technically, interest rates, yield spreads, and equities are forward looking. So, to argue against them would mean arguing against the predictions of the entire market. That’s not typically a sound idea.

        To Morgan’s point, though, government intervention centers around risk shifting from the organized takers of risk to less organized parties – taxpayers, for instance. This allows the risk takers to take far more risk for a given level of return than they would otherwise accept, leaving someone else holding the bag if it all goes against them.

        I suppose that it could be argued that savers and taxpayers have already paid for at least part of that risk as it is they who were robbed to recapitalize the banks. However, because government has bastardized markets so thoroughly, I’m not sure if the overall risk is really as low as this index implies. How much risk is not being priced in because it’s shifted to a third party?

      2. methinks and morganovich —

        This index does an excellent job of measuring risk reflected in various financial markets. It is not advertised as a predictor of events not seen in any market.

        It is extremely useful as an antidote to incessant repetition of unquantified headline risk. Reducing positions when the index gets above 1 helps to “right-size” your portfolio.

        The actual data series goes back to 1993. It is very well designed. If you would actually check out the index you would see that only a couple of the 18 indicators are directly related to Fed activities.

        Briefly put, it is nothing like your colorful analogies. I urge other readers to ignore what you both have said and go the site to learn more:

        Be sure to follow the link to the methodological appendix.

        1. Jeff,

          Thanks for the link. I will check it out.

          Fed activities are not my only concern. I have no doubt that the subsidized risk is reflected in various financial markets. My concern is that the financial markets aren’t pricing in all the risk because government is backstopping some of it. Do you think I’m wrong and if you do, why?

          1. morganovich


            and how would an index based on inputs that are being deliberately manipulated still yield the results it was supposed to?

            bond yields and spreads that were organically arrived at would demonstrate the perceptions of risk by market buyers.

            but if the bond market is flooded with non price sensitive buying with the specific purpose of driving down yield then a reading of 1 does not mean what it used to.

            it’s also a lousy measure of risk at the banks as it does not take leverage into account and the sort of low rates we see now tend to drive leverage up along with driving a shift into risk on trades as bonds have no real yield.

          2. As I said, it is incorrect to claim that these are all “manipulated.” There is no substitute for reading about an index. This is a VERY good principal components analysis (PCI). The series clearly does not follow what you think of as Fed manipulation — it follows events and uses many measures you would have to think about separately. I’ll list the inputs here —

            Interest Rates:
            • Effective federal funds rate
            • 2-year Treasury
            • 10-year Treasury
            • 30-year Treasury
            • Baa-rated corporate
            • Merrill Lynch High-Yield Corporate Master II Index
            • Merrill Lynch Asset-Backed Master BBB-rated
            Yield Spreads:
            • Yield curve: 10-year Treasury minus 3-month Treasury
            • Corporate Baa-rated bond minus 10-year Treasury
            • Merrill Lynch High-Yield Corporate Master II Index minus 10-year Treasury
            • 3-month London Interbank Offering Rate–Overnight Index Swap (LIBOR-OIS) spread
            • 3-month Treasury-Eurodollar (TED) spread
            • 3-month commercial paper minus 3-month Treasury bill
            Other Indicators:
            • J.P. Morgan Emerging Markets Bond Index Plus
            • Chicago Board Options Exchange Market Volatility Index (VIX)
            • Merrill Lynch Bond Market Volatility Index (1-month)
            • 10-year nominal Treasury yield minus 10-year Treasury Inflation Protected Security yield (breakeven inflation rate)
            • Vanguard Financials Exchange-Traded Fund (equities);
            accessed on Yahoo! Finance at

          3. Methinks — Government leaders, especially those of democratic countries, definitely see it as part of their job to control risk and to cushion the consequences. This is true of everything from having an army to providing Medicare.

            So yes, I agree that governments have helped to control risk. As an investor, this is just part of the reality. A number of prominent bearish pundits have complained that their predictions would have been correct had it not been for government. I prefer to include government as part of the equation — perhaps because it plays to my own skill set.

            Also please note that the SLFSI definitely showed much higher readings in Oct of 2011, despite whatever Fed or government actions was going on.

            It is just one tool — a coincident indicator of financial stress — but good for that purpose.

          4. morganovich


            and how would an index based on inputs that are being deliberately manipulated still yield the results it was supposed to?

            bond yields and spreads that were organically arrived at would demonstrate the perceptions of risk by market buyers.

            but if the bond market is flooded with non price sensitive buying with the specific purpose of driving down yield then a reading of 1 does not mean what it used to. much of this index is driven by merrill lynch bond indexes that have been driven way up because you cannot get real yield from unlevered treasuries. this flows through into the yield spreads etc and really queers the majority of this data pool.

            rate and rate spread models simply do not measure what they used to when you have CB’s this active in debt markets.

            it’s also a lousy measure of risk at the banks as it does not take leverage into account and the sort of low rates we see now tend to drive leverage up along with driving a shift into risk on trades as bonds have no real yield.

            personally, i would call being forced into risk on trades and leverage by the deliberate suppression of risk free yield by the fed to actually constitute financial stress, but those same things show up as its reduction in this model.

            it was not designed with this sort of intervention/manipulation in mind.

          5. morganovich


            are you seriously trying to claim that the fed has not been manipulating bond yields? then what would you call zirp, qe, twist, etc?

            and once such yields have been manipulated, are you seriously trying to argue that this does not flow through to spreads and other assets classes as investors are forced further out the risk curve to find yield?

            i really do not understand what you are trying to argue here.

            i know exactly what is in this index.

            further, while you are correct that leaders seem to feel it is their job to mitigate and cushion risk, they also have a truly dire track record of succeeding.

            we are currently in the longest string of concatenated bubbles in financial history. we go right from one to the next. bubble-bust-bubble with nothing in between.

            it was equity then real estate and now bonds.

            when this bond bubble bursts, it will make the last 2 look like a walk in the park particularly given the leverage involved.

            this is the direct result of governments trying to mitigate risk and repeatedly failing. just injecting liquidity over and over does not clear up a bubble, it just inflates a new one.

            back in the 90’s, we used to worry about the moral hazard around the so called “greenspan put”. the QE and zirp of helicopter ben makes such worries look positively quaint.

            i’m sure you are familiar with the axiom GIGO. how could we not apply that to this model at present? the rate info it is getting is heavily manipulated.

          6. Jeff,

            We’re talking past each other a little bit.

            First I have to address the fact that there is a big difference between “controlling risk” and doing what the government does – shift risk onto unsuspecting, unwilling and uncompensated third parties. Socializing losses and privatizing profits is not “controlling risk”. Thus, the government doesn’t “control risk” in any meaningful way, it merely forces at the point of a gun less organized parties to absorb losses of its cronies.

            If you are looking at the index from the perspective of an investor, then you are looking at it from the perspective of one whose risk is subsidized. That’s fine.

            If you are looking at it from the perspective of someone who is trying to assess how much financial risk there is, the picture is muddled because investors will price in the subsidy. In a completely unsubsidized market where the government has not socialized losses, what would the index look like?

            I don’t actually use this thing and I don’t know how important what I’m asking about is. I am not questioning the construction of the index and I do realize that “stress” may not be exactly synonymous with “risk”, but they are related.

          7. My dear friend and fellow commenter, Jon Murphy, just set me straight.

            Mark’s purpose in posting the stress index is to show that we’re not in a recession right now. No argument from me there. It’s not like risk shifting started in 2008.

            Nevermind! I retract my irrelevant musings. Thank you, Jon.

    2. Citizen B.

      “It’s not predictive…”

      “to amplify methink’s point, even if we were to accept that this index once held predictive power (itself a highly suspect proposition) …”

      Maybe it does have predictive value. When the reading goes under minus 1 then what follows is hyperbolic on the stress side? It looks like that is what happened ~nine months before the financial crisis began.

      1. morganovich

        i’d be careful extrapolating too much from one data point.

        i’d want to see several more datapoints and this index simply does not go back very far.,

        i could see the rationale that this index might provide a contrarian signal a ways before a spike as it tends to be the complacent aggressive investing that makes for tops but, i do not think there is enough evidence to verify or disprove that.

        1. Citizen B.

          OK, a possible contrarion indicator along with high bulls:bears and others.

          It looks like the “plowhorse economy” and Fed are making a stress comfort range, for now.

          1. Citizen B.

            Current bulls:bears individual investors sentiment 2:1.

            Current spelling of contrarion is now contrarian. :-)

  2. PeakTrader

    An inverted yield curve may be a better predictor of recession:

    “The Treasury yield curve inverted before the recessions of 2000, 1991, and 1981. The yield curve also forecast the 2008 financial crisis two years earlier.

    On July 17 2006, the yield curve inverted when the 10-year note yielded 5.06%, less than the 3-month bill at 5.11%. This was a few weeks after the Federal Reserve raised the Fed funds rate to 5.75%.”

    1. PeakTrader

      “An inverted yield curve is often a harbinger of recession. A positively sloped yield curve is often a harbinger of inflationary growth.”

      My comment: Structural changes, over the past few years, is creating an economy of too little growth and too much inflation.

      1. morganovich

        but again, in the age of ZIRP, how could you have an inverted curve?

        if bond yields are being manipulated and anchored at zero, then the cease to give the same signal they did previously.

        1. PeakTrader

          The Fed is making it harder for the country to fall into recession.

          1. PeakTrader

            Obama will need to work overtime :)

          2. morganovich

            i’m not so sure that’s true.

            at a certain point, low rates have done all they can and begin to do more harm than good as they reduce income for those living on savings dramatically and distort the economy and investment.


            david lays this out well.

            it also has the effect of pushing investors into riskier assets due to paltry yields and builds up systemic risk.

            this has been the weakest recovery from recession since modern gdp was calculated. that was true even before the q4 decline in gdp.

            but it has been one of the strongest equity market recoveries.

            that dichotomy is quite striking. somehting will have to give there. at some point, this firehose of money will have to be shut off.

          3. PeakTrader

            I guess, some people prefer recession over expansion and saving over spending.

            If you don’t believe me, who passed the comp exams in Money & Central Banking, and worked in banking and mutual funds, maybe you’ll believe Bob Brinker (Dec 2012):

            “It’s only because the Federal Reserve has been active that we have any growth at all in the economy….The Federal Reserve is the only operation in Washington doing its job.

            The only person that would criticize Ben Bernanke would be a person who is so clueless about monetary policy and (the) role of the Federal Reserve as to have nothing better than the lowest possible of education on the subject of economics….Anybody going after Ben Bernanke is a certified, documented fool….”

          4. morganovich


            your absurd blinders on this issue are well established. no need to go any further.

            guys like you who appeal to credentials as opposed to being able to actually engage in the topic generally have no idea what they are talking about. you’re whole comment was basically “david brinker says you are a stupidhead! ha!” like that demonstrates anyhting at all.

            you in particular have made it repeatedly clear that you cannot tell a bubble from and expansion and that you are unable to imagine than an economy can heal itself if not interfered with and believe that low rates are a panacea.

            bernanke is a wholesale disaster.

            he has painted us into a corner from which there is no way out save disaster. when this bond bubble bursts you are going to have some serious crow to eat.

            (and seriously, you want to put bob brinker up against one of the most successful hedge fund founders/managers in all of history as an appeal to authority? please. he’s a glorified talking head. if you are going to appeal to authority, at least choose an actual authority.)

            there’s no real point in engaging further with you here as i have seen the trajectory of your spiral into logical fallacy and bad data a sufficient number of times already.

          5. morganovich
          6. PeakTrader

            In a depression, you don’t want people to save more and spend less, and you don’t want to raise the cost of capital for households & firms.

            I stated before, asset booms and busts aren’t important. What’s important is maintaining sustainable economic growth (of goods & services).

            When there’s economic growth, spending and saving both rise.

          7. PeakTrader

            And, if political leaders in Washington did their jobs properly, the Fed would’ve completed a tightening cycle, by now, to slow the expansion and maintain sustainable growth, which is optimal growth.

  3. PeakTrader

    The Federal Reserve Bank of Cleveland is projecting 0.6% real growth in 2013:

Comments are closed.

Sort By:

Refine Content:


Additional Keywords:

Refine Results

or to save searches.

Refine Content