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Bank Stress Tests Are Cruel, but Fair: Street Whispers

Also under the new Adverse Scenario, short-term rates rise from their current range of between zero and 0.25% in order to combat inflation, reaching 2.5% by the end of 2013, while "the yield on the long-term Treasury note increases by less but still rises above 3.5% by the end of next year; thus, the yield curve is both higher and flatter in 2013."

Adding further to the misery under the Adverse Scenario, mortgage rates rise, while "corporate borrowing rates also move significantly higher, to more than 7% by the end of 2013, despite only a modest increase in spreads."

Severely Adverse Scenario

The Fed's new severely adverse scenario is similar to the 2012 adverse scenario, but nastier in some ways. "In the United States, the severely adverse scenario features a severe recession, with the unemployment rate increasing 4 percentage points from current levels (an amount similar to that in severe contractions over the past half-century). Notably, the unemployment rate remains above any level experienced over the last 70 years from the middle of 2013 to the end of the scenario."

The Federal Reserve also said that under the severely adverse scenario, domestic real GDP declines by almost 5% between the third quarter of 2012 and the end of 2013, with inflation slowing to 1%. Equity prices fall by over 50%, while housing prices and commercial real estate prices plunge by more than 20% by the end of 2014.

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Under the severely adverse scenario, "short-term interest rates remain near zero through 2015," while "the yield on the long-term Treasury note declines to 1.25% in 2013 before edging up about 1 percentage point by the end of 2015. Spreads on corporate bonds ramp-up to 550 basis points over the course of 2013. As a result, despite lower long-term Treasury yields, corporate borrowing rates rise and reach a peak of 6.75% in mid-2013."

Meanwhile, "the international component of the severely adverse scenario features recessions in the euro area, the United Kingdom, and Japan and below-trend growth in developing Asia," with the eurozone slipping "into recession in the fourth quarter of 2012 and remaining in this state until the end of 2013." According to various reports, the eurozone has already slipped into a recession.

The Fed said that "the main qualitative difference between this year's supervisory severely adverse scenario and last year's supervisory stress scenario is a much more substantial slowdown in developing Asia," including "a sharp slowdown" in China. "This feature of the scenario is designed to assess the effect on large US banks of the important downside risks to the global economic outlook that could result from a sizeable weakening of economic activity in China," the regulator said.

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