Potential Bumps Ahead for U.S. Financial Markets RYAN SWEET, DIRECTOR OF REAL-TIME ECONOMICS SOHINI CHOWDHURY, DIRECTOR May 2017
Financial Drag Can Be Significant Real GDP response to one std deviation in financial market stress 0.2 0.0-0.2-0.4-0.6 Annualized % change, ppt -0.8 Confidence band -1.0 Magnitude of response -1.2 X-axis is quarters from shock -1.4 1 2 3 4 5 6 7 8 Source: Moody s Analytics 2
1 Potential Bumps Ahead 3
Signs of Lofty Valuations Total market capitalization as a % of nominal GDP 160 140 +2 standard deviations 120 100 80 Historical avg 60 40 20-2 standard deviations 55 60 65 70 75 80 85 90 95 00 05 10 15 Sources: Federal Reserve, BEA, Moody s Analytics 4
Still Room for Rates to Rise 10-yr Treasury yield decomposed, % 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0-0.5-1.0 Inflation expectations Term premium Expected path of real short-term rates 10 11 12 13 14 15 16 17 Sources: Federal Reserve, Moody s Analytics 5
2 Here We Go Again, More Fiscal Brinkmanship 6
Brinkmanship Affects Interest Rates Yield on U.S. Treasury bills, % 0.4 1-mo 3-mo Government shutdown 0.3 0.2 0.1 0.0 9/3/13 9/17/13 10/1/13 10/15/13 10/29/13 11/12/13 Sources: Treasury, Moody s Analytics 7
Perceived Credit Risk Jumped 1.5 1.0 0.5 0.0-0.5-1.0 10-yr term premium, ppts (L) 1-yr CDS, bps (R) 10 11 12 13 90 80 70 60 50 40 30 20 10 0 Sources: Bloomberg L.P., Moody s Analytics 8
3 Easing Off the Throttle or Applying the Brakes? 9
Fed Will Be Patient Then Aggressive Fed funds rate, % 4.0 3.5 3.0 2.5 Eurodollar futures Moody's Analytics Fed-Mar SEP 2.0 1.5 1.0 0.5 0.0 Jun-17 Dec-17 Jun-18 Dec-18 Jun-19 Dec-19 Sources: Federal Reserve, Bloomberg L.P., Moody s Analytics 10
Uncertainty Not Unusually High Rolling six-week standard deviation of 2-yr Treasury yield, bps 45 40 35 Zero lower bound 30 25 20 15 First rate hike this cycle 10 5 0 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 Source: Moody s Analytics 11
A Misleading Relationship 1.0 0.8 0.6 0.4 0.2 0.0-0.2-0.4-0.6-0.8 09 10 11 12 13 14 15 16 Source: Moody s Analytics Correlation between level of S&P 500 and Fed balance sheet 12
Initial Runoff Is Heavy on Treasuries Maturity distribution of Fed holdings of U.S. Treasuries, $ bil 500 400 300 200 100 0 17 19 21 23 25 27 29 31 33 35 37 39 41 43 Sources: Federal Reserve, Moody s Analytics 13
4 What s the Deal With the Yield Curve and VIX? 14
Yield Curve Is Behaving as Expected Yield curve, bps 400 350 300 250 200 150 100 50 Actual Fitted 0-50 -100 02 05 08 11 14 17 Source: Moody s Analytics 15
Watching for Warnings of a Recession 16
What s the Deal With the VIX? 17
5 What Does Uncertainty Mean for Risk Factors? 18
Swap Spreads Will Elevate U.S. interest rate swap spreads, bps, NSA 140 120 1Y 3Y 5Y 10Y 100 80 60 40 20 0-20 02 05 08 11 14 17 Sources: Federal Reserve, Moody s Analytics 19
CDS Spreads Will Invert, Mimicking History North American investment grade CDS, par spread bid, bps, NSA 300 S4-scenario 250 1Y 3Y 5Y 10Y 200 150 100 50 0 06 09 12 15 18 Sources: Intercontinental Exchange, Moody s Analytics 20
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 1,000 750 500 250 0 06 09 12 15 18 Sources: Intercontinental Exchange, Moody s Analytics 21
Perceived Risk for Govt. Default Will Increase U.S. sovereign CDS, par spread bid, bps, NSA 80 S4-scenario 70 60 1Y 3Y 5Y 50 40 30 20 10 0 06 09 12 15 18 Sources: Intercontinental Exchange, Moody s Analytics 22
6 Financial Market Risk Forecasts Modeling Methodology 23
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
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
7 Financial Market Risk Forecasts Summary 26
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
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