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.
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.
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.
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.
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’.
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.
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.
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.
In a short note Macquarie’s commodity research reviews price distortions and prospective changes related to the warehouse system of the London Metals Exchange (LME). Since 2008 LME warehouses have effectively withdrawn over 4 million tons of aluminium from the physical markets, producing a record premium for physical delivery versus exchange spot prices. Premiums have also climbed for other metals. A future increase in mandatory load-out rates could compress premiums but also adds to uncertainty about the resulting adjustment in exchange prices.
Envisaged Fed tapering is simply predicated on five principles: (a) balance sheet expansion will slow and ultimately cease if unemployment declines on a sustained basis to around 7%, (b) the pace of asset purchases remains data dependent, hinging on sustained labor market improvement and financial conditions, (c) tapering is not meant to tighten monetary conditions, (d) tapering does not per se lead to subsequent unwinding of Treasury holdings and may never result in MBS sales, and (e) tapering does not per se bring forward Fed fund rate hikes, which are subject to higher thresholds.
Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for two decades. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.
