The Fed Introduced It’s 2018 Stress Test, and It’s Bad

The Federal Reserve released the details for its 2018 Stress Test.  It’s not pretty. They’re simulating a 65% drop to the equities market and a deep recession rather than their usual 50% drop.

As a part of the Dodd-Frank Act, “Too Big to Fail” banks must perform stress tests on their assets to make sure they have enough capital to absorb major losses and still lend.

What does this mean for us at HiddenLevers? First, we must update our scenarios to account for this new change. Second, we have a new scenario to set as a worst-case scenario. How awesome is it that you can do the same stress testing as the Federal Reserve?

What are the Federal Reserve’s Projections?

The Federal Reserve releases the details for their stress tests in a lengthy spreadsheet. I’ll boil it down to the big take-aways. The Fed is calling for a sharp decline to the equity market with a deep recession (GDP falling by 3.5% and 4.5%) in their adverse and severely adverse scenario.  Their baseline scenario is highlighted by steady GDP growth (2.5%), and mild inflation.

  Baseline Adverse Severely Adverse
S&P500 +5% -29% -65%
10 Year Treasury +.54 BP -2.12 BP Flat
12 Month T-Bills +.57 BP -1.96 BP -1.96 BP

Why is the Federal Reserve Calling for Such Sharp Declines?

The Federal Reserve, like HiddenLevers, separates their scenarios into a baseline, an adverse, and a severely adverse outcome.  The 2017 Severely Adverse scenario called for 50% drop in equities. Why are they using a 65% drop now?

As the economy runs hot and interest rates rise, banks are lending more and more money.  Meaning they have more and more liabilities. The Federal Reserve wants to ensure that these banks are staying in line with their required reserve balances.  The Fed wants to make sure, as the lender of last resort, that under another financial crisis they will not have to be called into action.

How Can Advisors and Asset Managers Use this Scenario?

In case you didn’t notice, the economy and stock market has been chugging along at a great pace. The S&P500 is up 350% since it’s bottom in early 2009. The Fed uses these scenarios to examine how big banks would handle a squeeze on their capital.

How would your clients handle a squeeze on their capital? At what point during that drawdown would your clients start calling in? Down 5%? Down 10%? Down 15%?

If you’re using HiddenLevers you already have a good idea on that number. Advisors and wealth managers use the 2008/2009 Financial Crisis as a worst-case baseline. Now, we can examine even deeper shocks to your clients’ portfolios using projections from the Fed!

Stress Test Your Portfolios Now

Log into HiddenLevers and try out our new scenario and let us know what you think. If you haven’t signed up yet try us out for free! You can stress test a 5-position portfolio against our new Federal Reserve 2018 Scenario.

Want to see how your model would handle that scenario? Schedule a time with one of our product specialists.

 

 

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