Despite the well-defined and ongoing credit crisis, the financial contraction triggered by the Lehman collapse was sudden, severe, worldwide and went beyond expectations, despite being telegraphed in advance. The Bloomberg Financial Conditions Index (BFCIUS), which is an equally weighted composite of money market instruments, bond market instruments, and equity market instruments, shows how severe and significant the financial shock was as it registered a nearly 12 standard deviation move from its pre-Lehman bankruptcy level.
Every trader should mark Sept. 15 (the day Lehman filed for bankruptcy) on the charts as a demarcation and landmark for evaluating market conditions. “Out of the frying pan …,” shows not only the precipitous drop in BFCIUS but also that conditions are moving towards levels seen prior to the bankruptcy.
It is very instructive to keep track of the individual components of this index since a great deal of expertise went into its construction. In total, there are 10 instruments (see “Gauging credit conditions”).
The selected components focus on measuring risk aversion in the market by tracking money market spreads, bond market spreads, and then adding the S&P 500 price and the CBOE Volatility Index (VIX).
While mapping a market recovery requires a watchful eye on several markets, there remains one major indicator that stands out as a leading financial conditions alert. The Federal Reserve’s quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices (this report introduced in 1967 can be found at: http://www.federalreserve.gov/boarddocs/SnLoanSurvey/), gauges the opinion of loan officers at banks, the people on the front line of the credit market. In the most recent report, 53 domestic banks and 23 U.S. branches and agencies of foreign banks were surveyed. This represents a significant sample of the institutions that are responsible for dispersing credit. It measures the willingness to lend money. Every recession since the mid-1950s was preceded by a credit crunch. The January survey showed that the signs were present both at the beginning of the contraction of credit and at its acceleration. It also showed the beginning of an easing of credit availability.
The search for signs of recovery has preoccupied financial analysts, but for currency traders it is as simple as watching the dollar. The dollar has been a “safe-haven” basket for capital because, despite disastrous U.S. financial conditions, the rest of the world’s financial conditions are worse. The normal inverse relationship between gold and the dollar has been in suspension as both have gained strength from their safe-haven status. This positive correlation is an outlier and can’t last. When gold and the dollar return to their normal inverse relationship, it will be a signal of more normal fundamentals. But with central banks around the globe adding supply, they also will have a collective stake in keeping gold reined in.
The commodity currency connection also offers the prospect for spotting a global recovery. Expectations of recovery likely will be reflected first in the copper market and in such currencies as Aussie and Canadian dollars.
The current crisis has thrown many sectors, forex in particular, into chaos as fundamental factors appear invalid. These indicators can provide a signal that a more normal relationship between fundamentals and market movement is at hand and allow traders to enter the market with more confidence.
Abe Cofnas is the author of “The Forex Trading Course” (Wiley), “The Forex Options Course” (Wiley) and the upcoming book, “Sentiment” (Bloomberg). Reach him at email@example.com