The dangers of ultra-low interest rates in Europe

May 3, 2015

Negative nominal interest rates and term premia are an issue for financial stability in Europe, according to a recent speech by the Deputy General Manager of the BIS. Duration risk has surged and banks’ exposure to sovereign credit and long-term rates has been compounded by flawed capital regulation. Governments find it easier to live with high debt levels for now, but at the expense of a weaker financial position of insurance companies and pension funds.

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The global systemic consequences of Solvency II

May 2, 2015

The new European insurance regulation will be introduced in 2016 with important consequences for the global financial system. A paper by Avinash Persaud argues that Solvency II introduces an undue bias against assets with high market and liquidity risk, such as equity. Meanwhile it encourages excessive holdings of low-yielding sovereign and high-grade bonds. (more…)

Mutual funds and market dislocations

April 26, 2015

The IMF Financial Stability Report highlights two systemic weaknesses of plain-vanilla mutual funds: incentives for end investors to rush for the exit in distress and incentives for portfolio managers to herd. With deteriorating market liquidity and greater systemic importance of collateral values, these weaknesses become a greater concern for the global financial system.

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Key global fiscal numbers and trends

April 25, 2015

The latest IMF fiscal monitor underscores three key fiscal trends. First, deficits in the developed world keep narrowing, thanks to past fiscal tightening and present economic growth Second, public debt ratios remain high and are unlikely to fall back below 100% of GDP this decade. Third, emerging markets fiscal numbers are deteriorating.

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Understanding and dissecting the variance risk premium

April 18, 2015

The variance risk premium is paid by risk-averse investors to hedge against variations in future realized volatility. Empirical evidence and intuition suggest that equity markets indeed pay over the odds for downside risk in mark-to-market variations but accept a discount for upside risk. The highest premium is paid for downside skewness risk. These forms of variance risk premia have been significant predictors of U.S. equity returns.

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The “collateral channel” of monetary policy

April 11, 2015

The importance of collateralized transactions for the global financial system has greatly increased since the financial crisis. Moreover, the influence of central banks on supply and pledgeability of collateral has become more pervasive and explicit. Investment managers must calculate with the impact of central bank policy and operating frameworks on financial conditions via this “collateral channel”.

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Why and when central banks intervene in FX markets

April 5, 2015

A new BIS paper summarizes motives and impact of FX interventions. Most importantly it looks at the conditions under which such interventions are effective (and hence likely). The strongest case for interventions arises when [i] the central bank has a clear view about an exchange rate misalignment, and [ii] the intervention would not go against the interest rate differential.

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Monetary policy risk management in the U.S.

April 3, 2015

A Chicago Fed paper argues that economic uncertainty at the zero lower bound (ZLB) should be a cause of looser monetary policy. This is basic risk management, as confirmed by Fed Chair Janet Yellen. Near the ZLB unduly tight monetary policy is more difficult to correct than unduly easy policy. Moreover, the mere risk of being constrained by the ZLB tomorrow affects expectations already today and can reinforce the severity of the ZLB constraint.

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How U.S. mutual funds reallocate assets

March 28, 2015

An empirical study shows that U.S. mutual funds take two major allocation decisions: bonds versus equity and U.S. versus non-U.S. assets. Federal Reserve policy easing encourages shifts into foreign assets. High uncertainty drives allocations out of risky assets into U.S. treasuries. And the relative performance of foreign versus U.S. assets leads a chase of the higher return. Within fixed income institutions tend to reallocate gradually towards higher prior yields.

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Commodity futures curves and risk premia

March 21, 2015

A Bank of England paper integrates commodity futures with bond yield curves. It finds that bond factors exert significant influence on commodities. It also finds that risk premia paid in crude oil futures have shifted over the decades from negative to positive, as crude’s hedge value faded with the memory of the oil crises. Gold futures have long paid a positive risk premium for lack of empirical hedge value.

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