It is evident that non-conventional Fed policy has contributed to long-term yield compression. It is less evident how this exactly worked and what will happen when the Fed tries to terminate QE and forward guidance. A new IMF paper supports evidence for two underestimated effects. First, to maintain existing stimulus the Fed must constantly announce new asset purchases or holding period extensions. Second, the stimulus from asset purchases depends on forward rate guidance and hence may decrease when the latter ceases.
Underestimated effects of the termination of QE and forward guidance
The global leverage problem
On aggregate, global financial leverage has further increased since the great financial crisis. Most worrisome is the declining debt service capacity of public and private borrowers due to falling potential GDP growth and inflation. This precarious development virtually enforces very low real interest rates. EM leverage has increased fastest in recent years. China in particular poses maybe the greatest global debt problem.
Volatility surprises
Volatility surprises are market moves outside the scope of expected volatility. They often bring to attention an underestimated type of risk. A paper by Aboura and Chevallier suggests that these volatility surprises transmit more easily across markets than return shocks. Moreover, the arising of unpredicted risk across markets seems to be cumulative.
A refresher of European banking union and AQR
Nicolas Veron explains European banking union and its acronyms. The two main pillars are the SSM (Single Supervisory Mechanism), run by the ECB, and the SRM (Single Resolution Mechanism), run by the SRB (Single Resolution Board). Before taking up its new role next month, the ECB will publish a stress test and an AQR (Asset Quality Review). The new framework is expected to ease the home bias of banking regulation and the sovereign-bank “doom loops”. Deficiencies include a lack of area-wide deposit insurance and insufficient resolution funds.
How to hike U.S. federal funds rates in a glut of liquidity
Asset purchase programs have left the U.S. banking system with USD2.9 trn in (mostly excess) reserves. Raising the target federal funds rate in this predicament relies primarily on increases in the interest rate paid on excess reserves. Moreover, in order to secure a sufficiently pervasive impact, overnight reverse repurchase agreements will likely play an important role. Their exact form will influence whether or not the target floor on money market rates will be “leaky”.
The pitfalls of emerging markets asset management
Dedicated EM exposure has surged by over 55% since 2007, with assets concentrated on few managers. A new BIS article points out that trading flows are correlated due to the widespread use of benchmarks. Moreover, EM asset prices and final investor flows have been pro-cyclical and mutually reinforcing. These patterns seem conducive to recurrent market dislocations.
Macroeconomic news and bond price trends
A new paper estimates that U.S. economic data explain more than a third of bond price fluctuations on a quarterly basis. The economic data impact on daily fluctuations is much weaker. It grows with the time horizon because economic factors are more persistent than non-fundamental factors. The simple powerful message is that economic news flow is crucial (and probably underestimated) for identifying market trends.
Understanding convenience yields
Convenience yield represents the implied interest paid for borrowing physical commodity. Holding physical inventories carries benefits of flexibility for industrial consumers. The value of such inventories increases when scarcities arise. As a consequence, convenience yields help predicting future demand and price changes. A new Bank of Canada paper illustrates this for the crude oil market.
When does shadow banking become a problem?
A new ECB paper explains key risk factors of shadow banking. First, if unregulated finance outgrows market size, tightening liquidity can escalate into runs and fire sales. Second, if shadow banks are operated by regulated banks they become a source of contagion. Third, and most importantly, if shadow banking focuses on regulatory arbitrage it erodes classical financial system safety nets.
Regulatory tightening: the basics and the basic risks
Financial regulatory tightening implies to some extent mutation of systemic risk. Thus, elevated bank capital requirements raise incentives for regulatory arbitrage and shadow banking. Liquidity regulation and OTC derivatives reform inflate holdings of government securities and help accommodating high public debt. And the emergence of central banks financial stability mandates and macroprudential policies may create misplaced confidence in crude and untested macro management tools.
