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.
Bank of Japan policy and long-term bond yields
A speech by Bank of Japan’s Takehiro Sato underscores that stabilizing long-term JGB yields has become a particular focus in the context of “Qualitative and Quantitative Easing”. This reflects the vulnerability of the country’s banks to higher yields (view post here), and the huge debt stock of the government. The Bank reckons that the sheer size and flexibility in its bond purchase program are at present sufficient to contain yield volatility and levels.
Shadow banking: A review of the basics
The New York Fed’s Economic Policy Review provides a basic overview of past and current shadow banking activities in the U.S. and beyond. Securitization and non-bank wholesale funding remain at the heart of the system. The relevance of shadow banking is likely to recover, as capital and liquidity standards in the regulated banking system are tightening.
Fire sale risk through the U.S. repo market
The Federal Reserve Bank of New York continues to highlight the latent risk of fire sales in the tri-party repo market. The danger arises from an incentive to liquidate collateral in case the solvency of a dealer is in doubt. The risk is enhanced by the vulnerability of the main cash lenders intri-party repos, money market mutual funds and security lenders, to liquidity pressure. Policy tools to contain such an event are limited.
The drivers of commodity price volatility
An empirical paper by Prokopczuk and Symeonidis investigates the drivers of commodity price volatility over the past 50 years. On the economic side inflation changes had been critical until price growth compressed over the past decade. Also economic recessions have been conducive to larger (industrial) commodity fluctuations. From the 2000s the importance of financial risk variables has gained weight, an apparent tribute to the “financialisation” of commodities trading.
Why CDS spreads can decouple from fundamentals
A Bundesbank working paper provides evidence that Credit Default Swap (CDS) spreads change significantly in accordance with (i) the direction of order flows, (ii) the size of transactions, and (iii) the type of counterparty. Apparent causes are asymmetric information, inventory risk and market power. The implication is powerful. Since transactions do not require commensurate changes in fundamentals and since CDS spreads are themselves used for risk management, institutional order flows can easily establish escalatory dynamics.
The full scope of U.S. federal government liabilities
James Hamilton from the University of California has published some scary numbers on growth and size of U.S. federal government liabilities that are not included in the official debt statistics. Their main constitutents are underfunded Social Security and Medicare liabilities, loan guaranties, and the federal deposit insurance. According to the Hamilton’s research ‘the total dollar value of notional off-balance-sheet commitments came to USD70 trillion as of 2012, or 6 times the size of the reported on-balance-sheet debt’.
Japanese banks’ vulnerability to rising bond yields
Standard & Poor’s research suggests that Japanese banks’ government bond holdings and interest rate risks of have almost doubled over the past 10 years. Against the backdrop of more aggressive reflation policies (view here) this translates into a systemic risk. An increase in long-term yields by 200bps compared to 2012 could already impair the banking system. An increase by 300bps or more could spell broadly based challenges for capital adequacy. A concurrent drop in equity would increase the pressure.
Asia’s systemic credit risks
A new Standard Chartered Research Report investigates pockets of potential credit risk in Asia, by using a new comprehensive set of metrics. China’s overleveraged corporates are at the forefront of concerns, as mentioned in other posts (view here). Japan’s massive 400% debt-to-GDP ratio is a potentially large risk if real interest rates in the country ever increase. India is burdened with a high government debt ratio and an apparently deteriorating profile of corporate debt.
New rules for euro area bank bailouts
Jacob Funk Kirkegaard, senior fellow of the Peterson Institute, has published an excellent summary on the euro area’s political deal for bank recapitalisation and resolution, targeted at breaking “doom loops”, i.e. escalating negative feedback of banking and sovereign solvency troubles. The key parts, from a market perspective, are (i) the possibility of direct recapitalisation of banks through the European Stability Mechanism (even retroactively) and (ii) stricter bail-in rules for private bond and equity owners.
