Potential Bumps Ahead for U.S. Financial Markets RYAN SWEET, DIRECTOR OF REAL-TIME ECONOMICS SOHINI CHOWDHURY, DIRECTOR
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1 Potential Bumps Ahead for U.S. Financial Markets RYAN SWEET, DIRECTOR OF REAL-TIME ECONOMICS SOHINI CHOWDHURY, DIRECTOR May 2017
2 Financial Drag Can Be Significant Real GDP response to one std deviation in financial market stress Annualized % change, ppt -0.8 Confidence band -1.0 Magnitude of response -1.2 X-axis is quarters from shock Source: Moody s Analytics 2
3 1 Potential Bumps Ahead 3
4 Signs of Lofty Valuations Total market capitalization as a % of nominal GDP standard deviations Historical avg standard deviations Sources: Federal Reserve, BEA, Moody s Analytics 4
5 Still Room for Rates to Rise 10-yr Treasury yield decomposed, % Inflation expectations Term premium Expected path of real short-term rates Sources: Federal Reserve, Moody s Analytics 5
6 2 Here We Go Again, More Fiscal Brinkmanship 6
7 Brinkmanship Affects Interest Rates Yield on U.S. Treasury bills, % mo 3-mo Government shutdown /3/13 9/17/13 10/1/13 10/15/13 10/29/13 11/12/13 Sources: Treasury, Moody s Analytics 7
8 Perceived Credit Risk Jumped yr term premium, ppts (L) 1-yr CDS, bps (R) Sources: Bloomberg L.P., Moody s Analytics 8
9 3 Easing Off the Throttle or Applying the Brakes? 9
10 Fed Will Be Patient Then Aggressive Fed funds rate, % Eurodollar futures Moody's Analytics Fed-Mar SEP Jun-17 Dec-17 Jun-18 Dec-18 Jun-19 Dec-19 Sources: Federal Reserve, Bloomberg L.P., Moody s Analytics 10
11 Uncertainty Not Unusually High Rolling six-week standard deviation of 2-yr Treasury yield, bps Zero lower bound First rate hike this cycle Source: Moody s Analytics 11
12 A Misleading Relationship Source: Moody s Analytics Correlation between level of S&P 500 and Fed balance sheet 12
13 Initial Runoff Is Heavy on Treasuries Maturity distribution of Fed holdings of U.S. Treasuries, $ bil Sources: Federal Reserve, Moody s Analytics 13
14 4 What s the Deal With the Yield Curve and VIX? 14
15 Yield Curve Is Behaving as Expected Yield curve, bps Actual Fitted Source: Moody s Analytics 15
16 Watching for Warnings of a Recession 16
17 What s the Deal With the VIX? 17
18 5 What Does Uncertainty Mean for Risk Factors? 18
19 Swap Spreads Will Elevate U.S. interest rate swap spreads, bps, NSA Y 3Y 5Y 10Y Sources: Federal Reserve, Moody s Analytics 19
20 CDS Spreads Will Invert, Mimicking History North American investment grade CDS, par spread bid, bps, NSA 300 S4-scenario 250 1Y 3Y 5Y 10Y Sources: Intercontinental Exchange, Moody s Analytics 20
21 HY Corporates Will Be Deemed as Most Risky North American high yield CDS, par spread bid, bps, NSA 2,250 2,000 S4-scenario 1,750 1,500 1Y 3Y 5Y 10Y 1,250 1, Sources: Intercontinental Exchange, Moody s Analytics 21
22 Perceived Risk for Govt. Default Will Increase U.S. sovereign CDS, par spread bid, bps, NSA 80 S4-scenario Y 3Y 5Y Sources: Intercontinental Exchange, Moody s Analytics 22
23 6 Financial Market Risk Forecasts Modeling Methodology 23
24 Consistent With Macro Assumptions Two-stage process to generate forecasts ensures consistency between projections for macroeconomic and financial series.» Forecasts of the core macro drivers are produced in Moody s Analytics country models.» Forecasts are produced under standard baseline economic conditions as well alternative assumptions provided by regulators, clients, or Moody s Analytics scenarios.» Market risk forecasts are conditional on macroeconomic assumptions and their equations are subject to detailed validation and robustness routines. 24
25 Term-Structure Modeling Steps» Decompose the variation in the rates/spreads across all maturities into the level and slope components of the yield curve.» Forecast the level and slope components using the macro driver projections from the Moody s Analytics country models. Ensures consistent forecasts of the rates/spreads and the macroeconomic variables» Forecast each individual tenor point on the yield curve as a function of the level and slope components. Ensures consistent forecasts of the various tenor points on the yield curve 25
26 7 Financial Market Risk Forecasts Summary 26
27 Financial Market Risk Forecasts Coverage, Consistency, Documentation» We produce forecasts of a full range of market risk factors, including government bond yields, interest rate swaps, credit default swap spreads, swaption volatilities, ABS spreads, muni and corporate bond spreads, currency basis swaps.» The forecasts are Internally consistent (rank ordering among the curves follows historical relationships) Consistent with the macro assumptions under a given scenario» We can produce these forecasts for the Moody s Analytics baseline and alternative scenarios, for the Fed CCAR scenarios, and for any other client scenario.» We provide detailed, equation-level documentation, which includes results from various econometric tests. 27
28 Learn more about our Financial Market Risk Forecasts Service: Talk to an expert: ma.moodys.com/contact-expert-market-risk.html
29 2017, Moody s Analytics, Inc. and/or its licensors and affiliates (collectively, MOODY S ). All rights reserved. ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY S PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODY S from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, all information contained herein is provided AS IS without warranty of any kind. Under no circumstances shall MOODY S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY S or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY S is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. The ratings, financial reporting analysis, projections, and other observations, if any, constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding, or selling. 29
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