(Bloomberg) -- It’s not hard to see the potential flash points on the horizon -- the U.S. presidential election; Deutsche Bank AG’s mounting legal charges; the day central banks stop buying bonds. Yet when it comes to gauging risks in the world’s financial markets, these days investors are flying more or less blind.
That’s because the once-dependable indicators traders relied on for decades to send out warnings are no longer up to the task. The so-called yield curve isn’t the recession predictor it once was. Swap spreads are so distorted they can’t be trusted. Even the vaunted VIX -- sometimes referred to as the “fear gauge,” is leading its followers astray, strategists say.
As central banks around the world pump billions of dollars into the global economy every month and policy makers pass regulations to safeguard against a relapse of the 2008 financial crisis, the market’s best and brightest say some warning signals are flashing at precisely the wrong time. Now, rules to shore up the money-market fund industry that kicked in Friday are stifling the predictive powers of yet another set of gauges. For investors, the big worry is they’ll end up being taken by surprise when the next crisis hits.
"I have a hard time believing what the actual information content of these indicators is," said Aaron Kohli, a fixed-income strategist in New York at BMO Capital Markets, one of 23 primary dealers that trade with the Federal Reserve.
Take a look at the London interbank offered rate.
Libor, the rate banks charge each other for dollar loans ranging from one day to one year, has surged to levels not seen since the financial crisis, even as the Fed has left interest rates unchanged this year. Rather than signaling a credit stress event as it once might have, the spike is the result of structural changes.
The new money-market rules have driven about $1 trillion from funds that buy the short-term debt of banks and corporations into those that invest in safer securities such as U.S. Treasury bills. As a result, banks’ unsecured lending rates have soared. Three-month Libor reached 0.88 percent on Oct. 14, the highest since 2009.
“There aren’t a whole lot of reasons to believe there are funding strains in these big financial institutions,” Kohli said.
The contortions are also seen in Libor’s spread with other rates.
The difference between Libor and the overnight index swap rate, another measure of bank funding stress that isolates credit risk, is at the widest since 2012.
And just last month, analysts at Goldman Sachs Group Inc. reminded investors how the so-called TED spread -- which tracks the difference between Libor and the yield on similar-maturity Treasury bills -- has lost its ability to foreshadow funding stress. They removed it from the bank’s proprietary financial conditions index.
"My concern is that when something comes to bite us in the butt, it’s not going to be something we’ve traditionally looked at," said Peter Tchir, head of macro strategy at Brean Capital LLC. "And it’s going to take a while for the markets to adjust."
Analysts are losing faith in the U.S. yield curve, a tool used to forecast the direction of the economy, as it signals a recession that many see as premature.
The curve is created by tracing a line through yields on bonds of different maturities. Normally, longer-maturity debt has higher yields than short-dated securities. When that inverts, it’s seen as a sign the economy is at risk of contracting. In fact, it’s happened before each of the past seven recessions.
While the curve has yet to invert, it’s flattened significantly. Strategists say the shift is the product of disentanglement between financial markets and macro-economics. The gap between yields on two- and 30-year Treasuries touched 1.4 percentage points on Aug. 30, the lowest since 2008.
“Perceptions that a flatter curve was presaging a recession were obviously wrong,” said Ward McCarthy, chief financial economist at Jefferies LLC. “We’re in one of the longest-running expansions on record. You have to look at the behavior of financial markets through the prism of central-bank policies, or central-bank balance sheets.”
In an even more esoteric corner of the market, a proxy for credit risk called the swap spread has been turned on its head not once but twice in recent months. The gap between the rate on interest-rate swaps and similar-maturity Treasury yields, another measure of bank credit quality, has been negative for most maturities for much of the past year as regulations made it cheaper and safer to use derivatives to hedge risk and more onerous and expensive for bond dealers to trade, hold and finance government debt on their balance sheets.
If that wasn’t enough, near-term swap spreads have swung back above zero this year -- not because conditions are normalizing, but rather due to money-market rule changes that are increasing banks’ borrowing costs in an already distorted market.
Two "of those proverbial canaries in a coal mine used to be Libor-OIS and short-term swap spreads, and they just don’t work as well these days," said Boris Rjavinski, an interest-rate strategist at Wells Fargo Securities LLC. "With all these changes, traditional indicators of financial stress aren’t working in the ways they used to."
Rjavinski suggested that even for a bond guy like himself, keeping an eye on the performance of bank stocks offers a better read on how worried the market is over risks to financial intermediaries like Deutsche Bank, which has seen its value plunge in recent weeks amid investor concern about the lender’s financial strength.
But even in equities, investors aren’t sure whether the tried-and-true market signals are as reliable as they once were. Years of unconventional stimulus by central banks have flooded the market with cash and suppressed volatility. To some analysts, the rise of passive investing has added another layer of complexity to how the stock market operates.
The CBOE Volatility index, the pulse of market fear measuring the implied volatility of the S&P 500, is becoming more erratic because of the proliferation of exchange-traded products, according to Pravit Chintawongvanich, an equity derivatives strategist at Macro Risk Advisors. These products offer investors exposure to VIX futures and magnify the speed and size of movements in the VIX itself.
"The big rebalance orders associated with VIX exchange-traded products means they are going to exacerbate the daily move in VIX futures, which could in turn impact the VIX," Chintawongvanich wrote in a note to clients. "So when volatility spikes, it spikes harder, and when volatility collapses, it collapses harder."
--With assistance from Liz Capo McCormick and Brian Chappatta. To contact the reporters on this story: Luke Kawa in New York at [email protected] ;Andrea Wong in New York at [email protected] To contact the editors responsible for this story: Boris Korby at [email protected] ;Tracy Alloway at [email protected] Mark Tannenbaum