Another (IMF) paper of Manmohan Singh deals with the influence of non-conventional monetary policy on collateralized borrowing. In past years, quantitative easing (QE) has absorbed collateral from private funding markets and, thereby, reduced private repurchase (collateral) rates relative to policy rates. An unwinding of central bank balance sheets in the future could increase the spread between policy and collateral rates – if the collateral finds its way on bank balance sheets – or reduce the degree of financial “lubrication” – if it ends up with non-banks. Put differently, in a large-scale QE unwind central banks could temporarily lose control over lending conditions.
Concerns over risk parity trading strategies
Risk parity portfolios allocate equal risk budgets to different assets or asset classes, most frequently equities and bonds. Over the past 30 years these strategies have outperformed traditional portfolios and become vastly popular. But a recent Commerzbank paper shows that outperformance does not hold for a very long (80 year) horizon, neither in terms of absolute returns, nor Sharpe ratios. In particular risk parity seems to be performing poorly in an environment of rising bond yields. And levered risk parity portfolios (“long-long trades”) are subject to considerable tail risk.
Broker-Dealer leverage drives credit and equity prices
A new New York Fed paper shows that financial intermediary leverage is one of the best performing explanatory factors for future credit and equity returns. High leverage growth compresses risk premia and reduces future excess returns.
A new Asian Crisis?
A Nomura research report looks at the rising financial risk premium across Asia. It shows that economic fundamentals are not as bad as they were in 1996. However, Asia’s external surplus has been eroded by a torrid financial expansion, which was fueled by very easy monetary policy. In the absence of a correction of this policy stance, there is an increasing danger that capital outflows will trigger a sudden stop to these accommodative financial conditions.
The dangers of leveraged ETFs
Leveraged Exchange Traded Funds have become a significant factor in the U.S. equity market. According to a new Federal Reserve discussion paper their mechanical rebalancing rules can reinforce or even escalate large directional moves in the stock market, both through their own transactions and other market participants’ front running.
Japan’s new policies and the threat of rising yields
A large rise in bond yields would threaten Japan’s sovereign solvency and banking system stability (view post here). New IMF econometric estimates suggest that the Bank of Japan’s quantitative and qualitative easing should lift yields just modestly, as rising inflation expectations would be offset by large public bond purchases. Meanwhile, the deteriorating fiscal trajectory could cause a 400bps rise in JGB (Japanese Government Bond) yields by 2030.
Understanding ECB forward guidance
ECB forward (policy rate) guidance has the declared intent to communicate the Governing Council’s reaction function and its assessment of the economy. It is not an unconditional pre-commitment and does not intend to generate above-target inflation. At the present juncture, forward guidance includes an easing bias.
Quantifying the impact of monetary policy rate guidance
A new DNB paper suggests that announcements by the U.S. Federal Open Market Committee on forward policy rate guidance have been credible and significantly reduced forward interest rates. Thus on average from 2008 to 2012, guidance announcements cut Eurodollar deposit rate 3 years forward by 14bps and 4-5 year forward Treasury yields by 20-21bps, over and above the impact of quantitative easing measures.
The euro area’s persistent de-leveraging
The ongoing economic misery of the euro area periphery reflects the compounded deleveraging of corporates, households, financial institutions, and governments. According to a new IMF paper, the process could still take years to complete. Simultaneous deleveraging across all sectors typically causes negative feedback loops, constraining economic growth and credit conditions.
Risks related to the Fed’s exit from ultra-easy policy
The IMF Article IV consultations for the U.S. suggest that a Federal Reserve exit from unconventional and highly accommodative policy may be challenging. Most importantly, quantitative estimates and past experiences indicate that the term premium on long-dated bond yields can vary greatly and become disruptive for markets and the economy. Meanwhile, the envisaged “passive” rundown of large treasury and MBS holdings would take a long time to unwind the Fed’s bloated and more risky balance sheet. And as long as excess reserves are ample even the Fed’s control over short-term rates will be imperfect.
