A Succinct Look At Risk Indicators

There are many moving parts in the financial markets, making predictions incredibly hard to do with any consistency. It’s my belief that earnings and interest rates are the main driver of stock prices over the long term. But liquidity conditions are also a very important piece of the puzzle and can have a large impact on short term trends. Let’s briefly look at where some important risk indicators currently stand.

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Yield Curve

The difference between the rates on 2-year and 10-year treasury bonds are as high as they have been in 3.5 years. The market is looking ahead to stronger economic growth and/or inflation expectations. The yield curve is one of the best leading indicators of recessions. When it drops into negative territory, it is a sign of internal stress within credit markets.

The trade war with China, along with the Fed raising rates, offset some of the benefits of lower corporate tax rates and reduced regulations. Credit conditions tightened from 2017 to 2019 – leading to a sharp decline in markets during Q4 2018 (Christmas crash) – until the Fed stopped raising rates and lowered them back to 0% again. Credit conditions are in much better shape today.

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St Louis Fed Stress Index

The St. Louis Fed Financial Stress Index incorporates a variety of important indicators to compile an index that shows how good/bad underlying financial conditions are. Economic recessions coincide with sharp increases in the stress index. Currently, the index is deep in negative territory, signaling underlying financial conditions remain positive.

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High Yield Credit Spreads

The next chart shows the difference between high yield (junk) bond rates in comparison to treasuries. Treasuries are considered the safest of all fixed-income investments, and during the bad times investors will demand a higher premium on junk bonds to compensate them for the additional risk. When times are good, and investors are more optimistic, this additional premium will shrink. Currently, the high yield spread hasn’t completely recovered from pre-COVID levels, but it's below the historical average.

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