Inflation differentials and equity returns

December 3, 2016

Inflation differentials and equity returns

There is evidence that equity markets fail to adjust to persistent cross-country shifts in inflation in a timely and efficient manner. While equity investors focus on tracking firm-specific price effects and cash flows, they seem to pay less attention to aggregate local inflation and appear sluggish in adjusting long-term discount factors across countries. Since equity is a long duration asset even small calibration errors in discount factors have a large impact. Empirically, real equity returns in lower-inflation markets tend to outperform those in higher-inflation markets. No such effect can be found in fixed income markets.

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Policy rates and equity returns: the “slope factor”

November 26, 2016

A long-term empirical analysis suggests that faster expected monetary policy tightening in future months leads equity market underperformance. The predictive factor can be modelled as a change in the slope in future implied future policy rates. It has had a meaningful and consistent effect on weekly U.S. equity returns for more than 25 years. Faster future policy tightening can mean either that the central bank has become more hawkish or that it has acted dovishly but thereby fallen behind the curve.

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The macroeconomic impact of Basel III

November 19, 2016

The regulatory capital reform for banks increases capital costs and credit spreads charged on clients. However, it also clearly reduces the tail risk of future banking system crises. And these crises have historically subtracted on average about 100% of an annual GDP overtime. Hence, a BIS paper finds that long-term growth benefits outweigh costs. One implication may be that once capital adjustment is complete and higher capital ratios are firmly established regulation headwinds for equity and credit markets turn into tailwinds.

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Term premia in the times of “lift-off”

November 12, 2016

Equilibrium models suggest that as long as the policy rate is firmly near zero, the term premium on longer-dated yields is compressed by a reduced sensitivity of rates to economic change. However, when policy rates are on the move again this sensitivity recovers, while proximity of the zero lower bound implies high economic risks and a surcharge on the term premia. Hence, term premium uncertainty would be highest at the time of “lift-off”, when policy rates are expected to move upward from near zero.

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The irrational neglect of optimal betting strategies

November 5, 2016

A recent betting experiment among finance students and professionals based on biased coin flipping revealed a wide gap between rational and actual behavior. The optimal strategy, which would have been constant and moderate risk taking (“Kelly criterion”), was not widely applied, notwithstanding education and training in finance. Instead, the experiment revealed a range of common behavioral biases. It challenges the general assumption of rational decision-making of finance professionals under uncertainty.

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The importance of statistical programming for investment managers

November 1, 2016

Almost every portfolio manager uses some form of quantitative analysis. Most still rely on Excel spreadsheets, but this popular tool constrains the creativity of analysis and struggles to cope with large data sets. Statistical programming in R and Python both facilitates and widens the scope of analysis. In particular, it allows using high-frequency data, alternative data sets, textual information and machine learning. And it greatly enhances the display and presentation of analytical findings.

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The impact of U.S. economic data surprises

October 29, 2016

A new paper estimated the short-term effects of U.S. economic data surprises on treasury notes and USD exchange rates over the past 20 years. All of 21 commonly followed data releases produced highly significant surprise effects at least for parts of the sample. However, only non-farm payrolls produced a consistently highly significant impact. After short-term interest rates reached the zero lower bound, the importance of surprises to CPI inflation, housing indicators and weekly jobless claims increased noticeably, possibly related to the Fed’s struggle with its dual mandate.

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The risk-adjusted covered interest parity

October 22, 2016

The conventional covered interest rate parity has failed in modern FX markets. A new HKIMR paper suggests that this is not a failure of markets or principles, but a failure to adjust the parity correctly for relative counterparty and liquidity risk across currency areas. Specifically, FX swap rates deviate from relative money market rates due to counterparty risk and from relative risk free (OIS) rates due to liquidity risk. Correct adjustment helps to detect true FX market dislocations.

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The global debt overhang

October 15, 2016

A new IMF report illustrates that a large share of both advanced and emerging economies struggle with private debt overhangs. Excessive debt is a drag on growth and a risk for financial stability. Low nominal growth has hampered deleveraging and aggravates these dangers. Moreover, high public sector debt has reduced governments’ capacity to support private balance sheets and stabilize economic growth in future crises. Therefore, the lingering debt overhang provides a strong incentive for fiscal and monetary policies to work towards higher nominal GDP growth now.

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Japan’s yield curve control: the basics

October 8, 2016

The Bank of Japan has once again broken new grounds in monetary policy, now targeting not just the short-term policy rate but – within limits – the 10-year JGB yield. In practice the Bank will secure a positive yield curve against the backdrop of negative short-term rates and negative expected long-term real rates. This is meant to mitigate the debilitating effect of yield compression on the financial system and, probably, to contain the risk of bond yield tantrums in case domestic spending and inflation do pick up. As a side effect, the policy would subsidize long duration carry trades and long-long equity-duration risk parity positions.

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