Weekly Commentary on Future Asset Values

Updated with data through October 17, 2014 new

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October 17, 2014 [PDF]


Commentary

Market uncertainty increased in the last two weeks, as illustrated by increases in the standard deviations of market-based probability densities (MPD) derived from equity, Treasury and oil markets. Expected inflation continued to decline. Market-based probabilities of high inflation descended to multi-year lows. Bank and Insurance company options also indicated higher uncertainty as spot prices fell. The spot price of crude oil fell ten percent, and the dispersion of the market probability density increased by 500 basis points. Expectations also skewed further to the downside for crude oil.

Inflation
Consistent with other metrics of inflation expectations such as TIPS-based breakeven rates or inflation swaps, median market inflation expectations over the next 12 months decreased by 38 basis points to 0.99 percent. Similarly, median inflation expectations over the next 5 years fell by 16 basis points to 1.82 percent. Market participants are pricing a higher likelihood of low inflation over the medium run and very low expectations of high inflation. The market-based probability of deflation over the next year was 14 percent and the market-based probability of inflation of less than 1 percent was 50 percent as of October 17th.

Chart 1

Large chart

Longer-term market probabilities moved similarly. The probability of inflation over 3 percent over the next 5 years has decreased to 10 percent and probability of inflation less than 1 percent has increased to 20 percent.

Chart 2

Large chart

Interest rates
Treasury yields declined across the yield curve over the last two weeks. The standard deviation of market probability densities for 5 and 10-year Treasury bonds rose and the MPD has skewed towards lower yields. The MPD standard deviation derived from 10-year Treasury futures has increased from 2.5 percent two weeks ago to 3.8 percent. The 10-year Treasury skew was close to neutral two weeks ago and is now at a 12 month high. For these reasons the market-based probabilities of large changes rose. Moreover, the probability of a bond price increase (a lower interest rate) is now greater than a bond price decrease (a higher interest rate).

Chart 3

Large chart

Banks and Insurance Companies
Patterns in the MPDs based on equity options for bank and insurance firms were dominated by broad market moves. Equity prices declined and uncertainty, as measured by MPD standard deviation, increased and MPD skew measures dropped. Financial firm share prices generally fared worse than the market as a whole. The average two week returns on bank and insurance company stocks were lower than the S&P 500. Average returns for large banks declined by 6.3%, insurance companies by 5.1% and the S&P 500 by 4.3%. MPDs were also influenced by earnings reports as many financial companies have reported their third quarter results over the past two weeks.

Over the past two weeks, MPD standard deviations increased by 3.9 percentage points on average. The standard deviation of the MPD derived from options on the S&P 500 index increased by a similar 3 percentage points.

Chart 4

Large chart

To a lesser degree, MPD standard deviations derived from options on insurance company equities also increased. The average MPD standard deviation rose 2.3 percentage points. While it is typical to see positive skews in a bottoming market, most skews became more negative in the last two weeks potentially foreshadowing further downward price moves. Generally these shifts occurred with options trading at relatively high volume.

Additional Details:

  • The MPD derived from options on of Citigroup share prices examplifies changes to the banking market-based probability densities. Note the increased dispersion and more negative skew. Citigroup had a positive earnings report and exceeded analysts expectations, options trading was elevated, and above average changes in standard devitation and skew relative to two weeks ago.

    Chart 5

    Large chart

  • The stock price of Deutsche Bank declined more than peers and ad the highest levels of uncertainty of large banks. The standard deviation of expected log returns on equity was 17.1 percent, increasing from 13.8 percent two weeks ago.
  • Shares prices for Lincoln National, Ameriprise, Prudential and Metlife had outsized declines. Returns decreased near -9% and standard deviations of market-based probabity densitieswere higher than peer insitutions.
  • Several major banks and insurance companies announced earnings during the data collection period which sometimes leads to higher volumes. These intitutions include Progressive, Citi, JP Morgan, Wells Fargo, American Express, Bank of America, Key Corp and PNC.

Other commodity markets
Commodity market price changes were mixed. Tail risks, as measured by MPD standard deviation, were similarly mixed. Prices for grains and metals increased and standard deviations of market based densities were roughly unchanged.

Additional Details:

  • Oil prices decreased by 10% over the last two weeks and the standard deviation of the probability distribution derived from crude oil futures increased by 5.3 percentage points to 18.8 percent. The MPD skew has become more negative, indicating greater downward tail risk. The following chart shows the probability of a 20 percent decline, which would currently mean crude oil prices below $63, is expected with 14% probability.

    Chart 6

    Large chart

  • Cattle prices declined slightly in the last two weeks after sustained increases. The standard deviation of the probability density for cattle is at a 15-month high, indicating increased tail risk.

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