Updated with data through December 10, 2014
December 10, 2014 [PDF]
Oil uncertainty, a stronger dollar, and lower inflation expectations continue to be the most significant trends. The probability of deflation has increased in the short run and longer run market-based probability densities (MPD) have shifted lower. Crude oil market probabilities remained skewed towards lower prices indicating more weight on larger declines.
The median of market-derived inflation probabilities based on inflation caps and floors with 1, 2, and 5 years to expiry fell significantly.Â The market probability for inflation below 1 percent for the next year is now 72 percent, the highest level in roughly five years of data.Â Similar trends are present for longer-term inflation horizons and the probability of deflation has become meaningful.
Volumes of options on Treasury futures were near recent averages. Market probability density skews continue their upward trends for long-term rates. In particular, market probabilities continue to suggest near-term downward pressure on ten-year rates.
Uncertainty around three-month LIBOR rates over the next 5 years as measured by MPD standard deviation continues to drop. The median of the MPD derived from caps and floors on the 3 month LIBOR in five years is also lower. Over the past year the expectations for short-term LIBOR levels over 3 and 5 year time horizons have converged and now differ by only 20 basis points.Â This means after initial increases expected over the next three years, market’s median expectation is flat. Medium run expectations for LIBOR have fallen moderately over the last 18 months.
Banks and Insurance Companies
Bank equity returns generally increased since the last report. The standard deviations of market probability densities increased by 120 basis points at the average bank which was similar to the change recorded S&P 500 MPD standard deviation. It is typical to see price increases accompanied by lower MPD standard deviations, but the opposite is true in the banking sector in this report. The higher uncertainty could be attributed to falling prices in broader equity over the last two weeks, which increased price uncertainty for bank equity. Insurance company equity prices were mixed following earlier increases. Trading volumes of options on bank equity were light and volumes of insurance options were average.
Other commodity markets
Oil prices have fallen further and the dollar strengthened broadly since the last report. Options markets indicate very high uncertainty in expected oil prices. The standard deviations of MPDs for commodities were generally higher.
The dollar strengthened against the euro, pound and yen since our last report. The standard deviation of the dollar-yen MPD increased to more than 6 percent. The probability of a future large decline in the dollar-yen exchange rate also climbed to 6 percent. This indicates greater uncertainty about the exchange rate and higher tail risk of a weaker yen.
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