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A Comprehensive Review of the Fed 2024 Stress Test Scenarios

Stress testing is a critical process in risk management used to evaluate how various economic scenarios can impact financial institutions and markets. It involves simulating extreme but plausible adverse conditions to assess the resilience of financial entities and the broader economic system. Stress tests help identify vulnerabilities, guide strategic planning, and ensure regulatory compliance.

Scenario Analysis

Scenario analysis is a fundamental component of stress testing. It involves creating different hypothetical economic conditions to see how they affect key financial variables in turn portfolios.

The Federal Reserve's 2024 stress test scenarios are designed to evaluate the resilience of the largest banks in the United States under hypothetical adverse economic conditions. These tests are crucial for ensuring the stability of the financial system and for assessing the capital adequacy of major financial institutions.

Here, we will explore two specific scenarios: the Baseline Scenario and the Severely Adverse Scenario.

Baseline Scenario

The Baseline Scenario represents a moderate economic trajectory for the United States, characterized by an initial slowdown followed by a gradual recovery. This scenario includes the following scenario definitions:

  • Real GDP Growth: GDP growth increases from 1.5% at the end of 2023 to 1.9% by the end of the scenario, indicating a gradual economic recovery.

  • Unemployment: The unemployment rate rises from 3.7% at the end of 2023 to 4.1% by the end of the scenario, reflecting a slight deterioration in the labor market before stabilization.

  • CPI Inflation: Inflation decreases from 2.8% to a trough of 2.2% in the second quarter of 2025, then remains stable, suggesting controlled inflationary pressures.

  • Short-term Treasury Rates: These rates start at 5.3% and fall to 3.1% by the end of the scenario, indicating an easing of monetary policy.

  • 10-year Treasury Securities: Yields on these securities decline from 4.5% to 3.6% over the 13-quarter scenario, showing a decrease in long-term borrowing costs.

  • Prime Rates: These rates follow the trend of short-term Treasury rates.

  • Mortgage Rates and Corporate Bond Yields**: Both decrease in line with long-term Treasury rates, reflecting a general decline in interest rates.

  • Equity Prices: Remain stable at their fourth-quarter 2023 levels throughout the scenario, with modest increases in market volatility as measured by the VIX.

  • Real Estate Prices: Nominal house prices and commercial real estate prices increase gradually by 1.5% per year, indicating moderate growth in the real estate market.

Severely Adverse Scenario

The Severely Adverse Scenario depicts a severe global recession with prolonged declines in both residential and commercial real estate prices, severely impacting the corporate sector and investment sentiment. Key assumptions in this scenario include:

  • Real GDP: GDP declines significantly through the first quarter of 2025 before starting to recover, indicating a sharp and deep recession.

  • Unemployment: The unemployment rate increases sharply in the first quarter and peaks at 10% in the third quarter of 2025, then gradually decreases, showing significant labor market stress.

  • Inflation: CPI inflation falls from 2.8% at the end of 2023 to 1.3% in the third quarter of 2024 and then gradually rises above 1.6% by the end of the scenario, reflecting deflationary pressures followed by a modest recovery.

  • Short-term Treasury Rates: These fall significantly to 0.1% by the third quarter of 2024 and remain low, indicating an aggressive monetary easing response.

  • 10-year Treasury Yield: Falls by nearly 3.7 percentage points by the second quarter of 2024, then gradually rises to about 1.5% by the end of the scenario. The yield curve is initially inverted in the first quarter of 2024, then steepens.

  • Corporate Bond Markets: Conditions deteriorate markedly, with spreads on BBB- rated bonds widening to 5.8 percentage points by the fourth quarter of 2024, indicating higher risk premiums. These spreads then gradually decline to 2.3 percentage points by the end of the scenario.

  • Mortgage Rates: The spread between mortgage rates and 10-year Treasury yields widens to 3 percentage points by the third quarter of 2024 before narrowing to about 1.6 percentage points.

  • Real Estate Prices: The House Price and Commercial Real Estate Price indices fall sharply through the third quarter of 2025 and then modestly increase from the lows by the end of the scenario.

  • Equity Prices: Fall 55% from the fourth quarter of 2023 through the fourth quarter of 2024 and do not return to their initial levels until the end of the scenario, indicating significant market turmoil and slow recovery.

Understanding these scenarios helps financial institutions prepare for potential economic downturns and recoveries. The Baseline Scenario provides a moderate outlook with gradual improvement, while the Severely Adverse Scenario highlights the risks of a severe recession and its impact on various financial metrics. By analyzing these scenarios, institutions can develop strategies to mitigate risks and ensure stability under different economic conditions.

These stress tests are crucial for assessing the financial health of banks and their ability to maintain required capital levels during economic turmoil. The results, which will be published in June 2024, will help regulators and banks prepare for potential future systemic risks and ensure that the banking sector can support the economy during adverse conditions.

By conducting these rigorous stress tests, the Federal Reserve aims to enhance the stability and resilience of the financial system, protecting it against unexpected economic shocks.

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