Credit Crisis Watch: Improvement In Financial Stress Index

I have often reported on the progress that has been made on the credit front and concluded as follows in my “Credit Crisis Review” of a few days ago: “Most indications are that the credit market tide has turned on the back of the massive reflation efforts orchestrated by central banks worldwide and that the credit system has started thawing.

“However, although the convalescence process seems to be well on track, it still has a way to go before confidence in the world’s financial system returns to more ‘normal’ levels, liquidity starts to flow freely again, and the economic recovery can commence.”

Further confirmation that the various central bank liquidity facilities and capital injections are having the desired effect of unclogging credit markets comes from Goldman Sachs’s Financial Stress Index (FSI). This index includes four factors related to the degree of impairment of financial markets: counterparty risk (US dollar 3-month LIBOR-OIS), liquidity risk (MBS to treasury repo differentials), refunding risk (commercial paper outstanding) and broader risk aversion (percentage of monies held in money-market mutual funds in relation to equity market capitalization).

As shown in the graph below, the FSI is now at the lowest level on a cyclically adjusted basis since the beginning of the credit crisis in August 2007.

“… the distress premium across assets has almost completely eroded. While the recent improvement [in the FSI] is largely due to the increase in risk appetite, indicated by money-market mutual fund outflows, there has also been improvement in other metrics as well,” said the Goldman team.

Source: Goldman Sachs - Strategy Matters, May 15, 2009.

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