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The St. Louis Fed’s Financial Stress Index, version 4

The FRED graph above depicts the St. Louis Fed’s Financial Stress Index (STLFSI). This data series in FRED was created in 2010 to measure changes in U.S. financial market conditions in response to a broad array of macroeconomic and financial developments. In particular, the STLFSI is designed to quantify financial market stress. There’s no specific definition for financial market stress, but periods of stress have historically been characterized by increased volatility of asset prices, reduced market liquidity conditions, or the narrowing or widening of key interest rate spreads. The STLFSI is constructed using 18 key indicators of financial market conditions—7 interest rates, 6 yield spreads, and 5 other indicators.

In late 2021, some Federal Reserve officials encouraged financial market participants and others to consider using an alternative short-term interest rate benchmark because of concerns about the eventual retirement of the London interbank offered rate (LIBOR). Since the STLFSI had two yield spreads based on the LIBOR, we replaced the LIBOR rate with the secured overnight financing rate (SOFR). Specifically, we shifted to the 90-day average SOFR. This rate measures the compounded average of the SOFR over a rolling 90-day period. In other words, it’s a backward-looking measure. We showed that the correlation between the previous version (STLFSI2) and the new version (STLFSI3) was 0.99 over the sample period dating back to December 1993. Click here for details and more information about this switch.

In 2022, we received numerous inquiries about the behavior of the STLFSI during the year. Most asked why the STLFSI was continuing to indicate lower-than-average levels of financial market stress, while other measures showed a “tightening” in financial market conditions. The divergence between the STLFSI and other indexes occurred more or less at the time when the Federal Open Market Committee (FOMC) began to signal its intent to raise its federal funds rate target in March 2022 and, importantly, subsequently signaled that further increases in the policy rate were likely in 2022—and perhaps in 2023.

Our analysis showed that instead of using the 90-day backward-looking SOFR rate, we should have used the 90-day forward-looking SOFR rate. In our view, using the forward-looking SOFR better captures financial market expectations in response to expected changes in the federal funds rate and its attendant effects on other asset prices and yields.

The second FRED graph plots the STLFSI4 and the STLFSI3 since early January 2020—just prior to the financial market turmoil and deep recession spawned by business and government actions designed to counteract the COVID-19 virus. In the graph, the two versions track each other closely over most of this period. But the close comovement began to erode in early February 2022, as it became clear that the FOMC was poised to begin raising its policy rate to combat an inflation rate that was the highest in 40 years. For example, the correlation between STLFSI3 and STLFSI4 was 0.993 from the week ending December 31, 1993, to the week ending January 28, 2022. Since the week ending February 4, 2022, the correlation has declined to 0.526.

A final takeaway from this second graph is that the new measure of the STLFSI shows that financial market stresses during the current Fed tightening episode are moderately higher compared with the previous version. Still, levels of financial market stress are currently near their historical levels. (In the index, zero is designed to be an “average” level of stress.) Moreover, the current Fed tightening episode has not triggered the kind of financial market stress seen during the heights of the pandemic-spawned shutdowns in the economy.

How these graphs were created: Search FRED for “Financial Stress Index” and make sure to take version 4. For the second graph, take the first, click on “edit graph,” open the “add line” tab, and search for “Financial Stress Index,” making sure to take version 3.

Suggested by Cassandra Marks, Kevin Kliesen, and Michael McCracken.

Real returns on major asset classes since the start of the pandemic

In the beginning of 2020, as the COVID-19 pandemic seemed likely to spread in advanced economies, financial markets entered a period of turmoil. Some even thought the world was headed for a financial crisis. But after the deployment of major fiscal and monetary policy interventions around the world, among other factors, such a crisis never materialized. In fact, financial markets performed exceptionally well by historical standards in the periods following the pandemic recession of the second quarter of 2020.

The FRED graph above plots the cumulative real returns on three major classes of assets held by U.S. households—stocks, real estate, and corporate bonds—since the last full month before the pandemic, December 2019. It’s useful to unpack this definition. First, these returns are cumulative: At each date, they measure the return obtained by someone who purchased the asset at the initial date (December 2019) and sold it at that given date. Second, these returns are real, meaning they’re adjusted for inflation.

Stocks (in blue). The graph shows that stocks, measured by the S&P 500, did not perform well in the early stages of the pandemic: The blue line falls below 1 in the first few quarters. But stocks boomed in the following periods. At its peak at the end of 2021, the real cumulative return on the S&P 500 index was around 36%. Cumulative returns have fallen since then, but were still equal to 5% as of September 2022.

Real estate (in red). Cumulative returns on housing rose steadily until May, peaking at over 27%, and had fallen slightly as of the last available observation.

Corporate bonds (in green). Finally, corporate bonds have not done so well: Their cumulative return peaked at 8% at the end of 2020, but has fallen ever since: It was –20% as of September 2022. Bond returns typically underperform in high-inflation situations.

How this graph was created: Search FRED for “S&P 500” and click “Edit Graph.” For “Units,” select “Index (Scale value to 100 for chosen date)” and set the date as 2019-12-31. Add a series, “Consumer Price Index for All Urban Consumers: All Items in U.S. City Average,” and apply the same transformation (Index set to 100, date 2019-12-31). Modify the frequency to monthly, using “Average” as the aggregation method. In the formula field, type “a/b.” At the top, click on “Add Line” and repeat these exact steps for “S&P/Case-Shiller U.S. National Home Price Index.” Repeat one final time for “ICE BofA US Corporate Index Total Return Index Value” and set the starting date of the graph to 2019-11-30 and the final date to 2022-09-01.

Suggested by Miguel Faria-e-Castro.

How war impacts bond markets

An instructive example from the U.S. Civil War

How and why do financial markets react to war? One aspect of war is to endure losses, and financial markets typically don’t respond enthusiastically to even the risk of loss, let alone widespread destruction on their own soil. Markets may also rise and fall over the course of the war as the fortunes of the warring parties change.

FRED has a peculiarly helpful dataset that provides examples of this dynamic: Weekly U.S. and State Bond Prices, 1855-1865. The authors, Gerald P. Dwyer Jr., R. W. Hafer, and Warren E. Weber, compiled a time series of bond prices for some U.S. states leading up to and through the U.S. Civil War.

The FRED graph above shows bond price data for two states in the South (Virginia and Louisiana) and two states in the North (Pennsylvania and Ohio).

The bonds in question were used for infrastructure, such as roads, canals, and railroads. The war’s potential to destroy that infrastructure could affect the ability of states to pay back the bonds. More generally, war disrupts productive capacity, impedes the raising of tax revenue, and ramps up state expenses—all of which increases the likelihood of state default.

Not surprisingly, the graph shows increasing risk, with prices dropping in late 1860 and then plunging as hostilities began in 1861. These effects were more pronounced in the South than in the North. And the graph also shows that Southern bonds stayed low as the war unraveled, while Northern bonds roughly returned to parity.

How this graph was created: Search FRED for “disunion bonds” and click on, say, Virginia. From the “Edit Graph” panel, use the “Add Line” tab to search for and select the other states.

Suggested by Christian Zimmermann.

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