The market is currently in a state of financial dissonance, a cause for confusion and discomfort for many investors trying to resolve the barrage of conflicting messages they hear on a daily basis.
Like its psychological counterpart—cognitive dissonance—the financial kind is just as distressing. Whenever individuals or investors are confronted with simultaneously conflicting messages, there is a strong motivation to resolve the discrepancy until the more desirable—hopefully, more accurate—condition wins out.
In our case, the conflict is developing between the stock market and the credit market (also known as the bond market). On Friday, the S&P 500 rallied for a fourth day in a row to finally reach positive territory for the year. The Dow is also nearing its six month high, leading some market commentators to ask the question: "Are good times ahead?"
On the other hand, if you look at the much larger and more important picture playing out in the credit markets, a very different scenario emerges. As the stock market has been slowly climbing, over the same time rates charged by banks for lending here and in Europe have been signaling greater fear and uncertainty over the health of the financial system. Clearly, the underlying picture hasn't improved much.
As far as which market will eventually win out, as stated above, the credit market is much larger and a far more important gauge of financial health. For example, as Tom Lauricella writes in the Wall Street Journal, "during the 2008 financial crisis they [the credit market indicators shown below] became seen as a kind of canary in the coal mine, and hedge fund and prop traders added them to their models and must-watch lists. When they see a rise in these spreads, the response is 'risk off', which means dumping stocks, euros, oil, etc."
So far, they haven't reached quite the levels experienced during 2008 but, as you can see below, the "risk off" scenario has been slowly gaining momentum apart from the seasonal Christmas rally and improving U.S. economic conditions. Overall, we need to see many of these fundamental indicators start to improve before placing too much confidence in the market's current direction. Check back in with us as we'll continue to give updates on these and many other "canary in the coal mine" risk indicators in the weeks and months ahead:
Bank overnight lending rates
Rates charged between banks for short-term financing and liquidity needs. An increasing rate reflects financial uncertainty and decreasing confidence among banks.
US TED spread
From Wikipedia: "The TED spread is an indicator of perceived credit risk in the general economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. When the TED spread increases, that is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. Interbank lenders, therefore, demand a higher rate of interest, or accept lower returns on safe investments such as T-bills. When the risk of bank defaults is considered to be decreasing, the TED spread decreases."
Euro TED spread
FRA-OIS spread
From the Wall Street Journal:
The FRA-OIS indicator is a cousin to the more widely known (at least among macro traders) Libor-OIS spread. Both of these indicators are viewed as a reflection of banks willingess to lend money to each other. A spike in these rates suggests a growing fear among banks about letting a competitor borrow. When banks won’t lend to each other, you’re in trouble.
