SigmaQ Corporate Default Risk Technology

On February 9, the FED released its 2023 CCAR scenarios for this year’s bank stress tests. This is one of the more important CCAR exercises in recent years. For the first time, the FED has published an additional exploratory market shock scenario.

This exploratory market shock scenario “is characterized by a less severe recession with greater inflationary pressures induced by higher inflation expectations”. It thus reflects the FED’s recently expressed view that inflation might stay elevated and that additional rate increases could just be luring around the corner (rate increases are embedded actually in the exploratory scenario). Although this exploratory market shock scenario will not add to the capital requirements set by the stress test and will only apply to US G-SIBS, the outcome of it “could reveal different losses across banks, depending on the positions held in their portfolios” and should thus be of interest to all market participants, not just the US G-SIBS.

So let’s take a closer look at this exploratory scenario and its impact on corporate bond default risk. We do this by analyzing it for some SigmaQ PD sector indices. These sector indices are formed from SigmaQ default probabilities of several hundred companies in each sector. Using SigmaQ’s macroeconomic modelling suite, we identify the significant macroeconomic factors and then perform the scenario analysis. For this, we work with the FED’s dataset for the macro-economic factors (historic for calibration as well as scenarios for forecasting).

We show the results of this analysis for two sectors here (in case you’re interested in the other sectors, just drop us a note): consumer discretionary and financials. Clearly, the expectation is that the sector consumer discretionary should be more affected by an inflation focused scenario. The analysis confirms this economic intuition: the exploratory scenario has a more significant impact on PDs in the consumer discretionary sector than in the financials sector as can be seen in the two figures below.

Looking more closely at the FED scenarios, it almost seems as if the FED is more concerned about continued high inflation than a recession: for consumer cyclicals, the exploratory scenario’s impact even exceeds the adverse scenario. In addition, unlike the negative scenario, which has a similar impact on both sectors, the exploratory scenario appears to have been designed to better distinguish the impact of high inflation across sectors. So there is no doubt that this scenario “will reveal different losses for banks depending on the positions they hold in their portfolios.”

Just adding to this picture, in their exploratory market shock scenario, the inflation shock essentially goes hand-in-hand with the interest rate shock (see figure below). One could argue that predicting interest rate changes simply depends on where inflation is headed, and that there is no need to ask how the FED would respond.

The key takeaway? If the FED’s current market assessment comes true and the exploratory market shock scenario becomes reality, some portfolios could be affected even more than in a severe recession. A good reason, then, to have banks analyze their portfolios under such a scenario.