ECB summary of China’s imbalances and risks

February 9, 2013

The ECB’s new “due diligence” paper on China reiterates why severe imbalances are inherent in the country’s high-growth model. Without a fundamental overhaul the key imbalances, such as overinvestment, large state control, and financial repression are likely to persist. For now, supply side conditions suggest that this model may still deliver sufficient (8% or higher) GDP growth. Yet as trend growth will inevitably slow, severe tail risks such as “widespread corporate defaults, systemic banking sector stress and social unrest” are looming.

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How inventory levels affect commodity futures curves and returns

January 27, 2013

A new Review of Finance article investigates the link between commodity inventories on the one hand and futures returns and curve backwardation on the other. Most prominently, low inventories mean that the convenience yield of physical holdings is high (more need of insurance against a “stock-out”). In this case, producers and inventory owners are willing to pay a surcharge for immediate access to the physical. This will (normally) translate into a higher risk premium, more backwardation, and higher expected excess returns. Moreover, external factors, such as price volatility, can induce producers and physical inventory holders to pay a higher premium for future price certainty that translates into a positive basis and expected return on futures positions. The inventory connection explains why commodity futures returns and futures curve shape are correlated, i.e. backwardation is more often than not a profit opportunity. According to this paper, mainstream theory is backed by empirical evidence for 31 commodities over more than 40 years.

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Currency dynamicis in risk-off episodes

January 14, 2013
A new IMF paper suggests that there is much more to exchange rate dynamics in “risk-off” periods than correlation-driven risk shedding. Indeed, it provides evidence that economic fundamentals, particularly external balances, re-assert themselves precisely during the first twelve weeks after market turmoil has erupted, when the asking price for incremental economic and policy risk is steep.

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Risks related to central counterparties in derivatives markets

January 11, 2013

The large volumes of notionals and market values in OTC (rates and credit) derivatives markets have spurred a regulatory enhancement of risk buffers at banks. However, an IMF working paper by Li Lin and Jay Surti points out that no commensurate prescriptions apply to the two monopolistic central counter parties (CCPs) that clear a large share of the OTC derivatives market. This bears the risks that CCPs could become a medium of regulatory arbitrage of even systemic pressure.

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BIS on safe asset shortage and need for low real interest rates

January 6, 2013

A recent BIS working paper reminds us that the securitized credit and euro area sovereign credit crises have structurally diminished the world’s reserves of perceived safe assets. As safe assets are essential for institutional finance (pensions, insurances) and transactions (collateralization) their continued shrinkage would propagate a financial sector meltdown. This is why persistent negative real interest rates on sovereign and central bank liabilities are a critical stabilizer: they increase safe asset supply, reduce demand, and stabilize the finances of sovereign borrowers. Central banks play the lead role in sustaining this real rate compression, as they have often done in history.

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The tipping point in the Japanese government bond market

December 19, 2012

Low government bond yields (0.76% for 10-year maturity at present) allow Japan to preserve debt sustainability despite a gross debt-to-GDP ratio of over 220%. However, a working paper published (a while ago) by Takeo Hoshi and Takatoshi Ito argues that a tipping point may be ahead. Thus far yields have been kept low thanks to large domestic savings with a strong home bias and low returns in other assets. Under current trends, however, the nominal public debt stock will have reached the overall level of private sector financial assets by 2016. Meanwhile, attempts to reflate assets and stimulate the economy will raise the opportunity costs of holding government debt.

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Solvency issues of European insurances

December 18, 2012

The latest ECB’s financial stability report has a short but insightful section on the position of the EU insurance sector. While financial positions according to current (Solvency I) standards seem satisfactory, the ECB fears that “a persistent low-yield environment could become a major solvency risk in the medium term”. The planned introduction of the EU’s Solvency II directive in 2014 and the related prospective marking to market of liabilities in a majority of countries could make this issue more obvious.

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U.S. Fed: Why replacement of “operation twist” with outright bond purchases makes a difference

December 17, 2012

JP Morgan’s Nikolaos Panigirtzoglou presented a nice reasoning, why the December 12 2012 U.S. Fed decision to replace its maturity extension program with outright bond purchases of the same size will put in place an important additional influence on long-term treasury yields. This influence is an intensified “liquidity affect” over and above the previous “demand effect” on government bonds.

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Why is volatility so low while uncertainty is still so high?

December 15, 2012

This note from Claudio Irigoyen and others supports the notion that implied volatilities naturally return to long-term trend even if economic uncertainty does not. While implied volatility is very sensitive to deteriorating conditions, actual and implied volatility under poor but stable conditions may be compressed by investor adaptation (defensive repositioning, risk management changes, easing risk aversion, etc.) and policymakers’ direct market intervention (liquidity supply, policy puts, etc.). Technically speaking, the first derivative of economic uncertainty indicators may condition the mean reversion of implied volatility.

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