Interrelationships among U.S. Financial Risks, Economic Activity and Oil in a Regime-Changing Environment

This paper investigates directional relationships, regime variances, transition probabilities and expected regime durations for a system of economic and financial risk variables in the U.S. markets. The system is based on monthly data, and encompasses credit, and market risks and economic activity variables. The methodology is based on the Markov-Switching cointegrated VAR model and their impulse response functions for two regimes. The results suggest there is a pronounced regime-specific behavior in the system. There is a significant difference between the higher expected duration in the low volatility regime and the lower duration in the high volatility regime. During the 2007/2008 Great Recession, the system stays mainly in the high volatile regime but returns to the normality state in the 2009 recovery period. The fundamental variables (industrial production, oil price and the real interest rate) have varying effects on the financial market risks across regimes. The economic activity has more impacts on the financial risks than the other way around in both regimes, while the impact in the low validity regime is more profound. Quantitative easing has significant effects on both the stock expected volatility index VIX and the bond expected volatility index MOVE in the low volatility. I also examine the driving forces of the time-varying transition probabilities and find that increases in oil price will decrease the probability that the financial markets stay in the low volatility regime. Policy implications are also discussed.