OF late, the US market is acting weirdly. It is really a paradox. Though different macroeconomic indexes, e.g., rate of unemployment, consumption, manufacturing, consumer confidence index, Chief Executive Officer (CEO) confidence index etc., are showing some red flags about the US economy, some readings that represent market's expectation, e.g., VIX, TED spread etc., about future uncertainty are more optimistic about the economic future than it was in September 2008! In finance, we are always told that market is smarter than you. Market as a whole can predict things better than a trained individual. But it looks like that this time market is not guessing future uncertainty wisely, at least for near-term!
VIX, also used as the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, a popular measure of the market's expectation about implied volatility in S&P 500 index options over the next 30-days period. A high value corresponds to a more volatile market over the next one month. For new readers, this writer would like to mention that the S&P 500 is a value weighted index of 500 large cap common stocks traded in the USA. Almost all stocks included in the index are among the 500 American stocks with the largest market capitalizations. However, VIX is expressed in terms of percentage points in an annualized basis. For example, if the VIX is at 50, this represents that market expects an annualized change of 50 per cent over the next 30 days or there is 68 per cent likelihood, i.e., one standard deviation that the magnitude of the S&P 500's 30-day return will be about 14.43 per cent up or down. Though until October 2008, the average value of VIX was 19.04, on October 24, 2008, the VIX reached an intraday high of 89.53.
On the other side, the TED spread is the difference between the three-month Treasury (T)-bill interest rate and three-month London Inter-bank Offered Rate (LIBOR). A TED spread is in general a broad indicator of perceived credit risk in the economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. A rising TED spread often indicates that liquidity is being withdrawn and also shows concern about the solvency of the banking system. When the TED spread increases, lenders believe the default risk on inter-bank loans, i.e., counterparty risk is increasing. Inter-bank lenders therefore demand a higher rate of interest, or accept lower returns on safe investments such as T-bills. Accordingly, when the risk of bank defaults is considered to be decreasing, the TED spread decreases.
The TED spread fluctuates over time, but historically it has often remained within the range of 10 and 50 bps (0.1 per cent and 0.5 per cent), until 2007. The long term average of the TED has been 30 basis points with a maximum of 50 bps. However, during 2007, the sub-prime mortgage crisis, the TED spread skyrocketed to a region of 150-200 bps. On October 10, 2008, the TED spread reached another new high of 465 basis points.
September 2008 will be remembered in financial history of the USA. Why? On September 15, 2008, Lehman Brothers filed for Chapter 11 bankruptcy protection which is marked as the largest bankruptcy in US history. And, on September 14, 2008 Bank of America (BOA) announced its intention to acquire Merrill Lynch. On September 16, 2008, Bruce Wallis's money market fund, Reserve Primary, "broke the buck", i.e., its net asset value went below $1.0. There was so much uncertainty in September, 2008. And thus both TED spread and VIX were on their record high. Though there was enough uncertainty in last September, it was limited mainly in the banking sector which was lacking liquidity and, most importantly, trusts.
And, now economists are concerned about the whole macro-economic condition in the US rather than any particular sector or industry. The US economy lost 598,000 jobs in January, pushing the unemployment rate to a 16-year high of 7.6 per cent. Meanwhile, new home sales are 10.2 per cent below the revised December rate of 344,000 and 48.2 per cent down from a year earlier. Recent gross domestic product (GDP) report showed that the economy fell at a 6.2 per cent annual pace at the end of last year, a much faster than expected pace. Year-to-date (YTD), S&P 500 dropped 45 per cent and DJIA dropped 19 per cent. Prof. Dimson from London School of Business estimates that we'll have to wait nine more years before the Dow average, including dividends, has a 50 per cent chance of hitting its 2007 highs. Because of "flight to quality," yield on 10-year treasury is beaten down below 3.0 per cent. Again gold price per ounce already crossed 1,000 dollar. Moreover, there is also a fear that the US banking system might be nationalized at least for the short-term which will dilute or eradicate present shareholders position in the company. However, the good news for the US is that Consumer Price Index (CPI) for January rose by 0.3 per cent. Core CPI, i.e., CPI for all items excluding food and energy showed an increase of 0.2 per cent.
Thus, here is the paradox: though economists see much uncertainty right now than it was in September 2008, market perception about future uncertainty is relatively optimistic if we compare the situation with that of the last September. Market believes that future uncertainty is relatively lower than it was in September 2008! And, we need to wait for a while to see who is right.
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