Bank of Japan Governor Shirakawa emphasized his instutions strengthened mandate to end deflation. The key decisions were the introduction of a 2% inflation target and the initiation of a new open-ended Asset Purchase Program.
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.
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.
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.
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.
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.
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.
In an easily readable working paper Stephen Cecchetti and colleagues explain the connection between euro area break-up concerns, Target2 balances, and financial conditions. This research would support the idea that commitment to 100% euro zone stability, via OMT and other measures, is the most effective form of monetary easing in the euro area.
A new IMF paper investigates the role of shadow banks in securitization and collateral intermediation. One important forward-looking concern is the potential vulnerability of collateral chains, i.e. the use of a single security for multiple secured loan transactions.
