ECB asset purchases: the three transmission channels

September 24, 2016

A new paper suggests that ECB asset purchases influence markets and the economy significantly, mainly through three channels. First, through the asset valuation channel they reduce risk premia and provide capital relief to leveraged institutions, particularly banks. Second, through the signalling channel they enhance the credibility of rates staying low for long. Third, through the re-anchoring channel, asset purchases can reassure the private sector that the central bank remains committed to its long-term inflation target.

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Selecting macro factors for trading strategies

September 17, 2016

A powerful statistical method for selecting macro factors for trading strategies is the “Elastic Net”. The method simultaneously selects factors in accordance with their past predictive power and estimates their influence conservatively in order to contain the influence of accidental correlation. Unlike other statistical selection methods, such as “LASSO”, the “Elastic Net” can make use of a large number of correlated factors, a typical feature of economic time series.

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What made FOMC members hawkish or dovish?

September 14, 2016

An empirical analysis based on transcripts of the U.S. Federal Open Market Committee from 1994 to 2008 suggests that differences in committee members’ policy differences can partly be explained by differences in regional data, particularly unemployment rates. Also, personal background may play some role: FOMC members with experience in the non-financial private and public sectors have historically been more dovish.

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Mutual fund flows and fire sale risk

September 10, 2016

A new empirical paper looks at the drivers of U.S. mutual funds flows across asset classes. An important finding is that changes of monetary policy expectations towards tightening trigger net outflows from bond funds and net inflows into equity funds. Typically, the costs of redemptions are borne by investors that do not redeem or redeem late. This creates incentives for fire sales and causes of price distortions, particularly if the outlook for monetary policy is revised significantly.

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Corporate bond market momentum: a model

September 3, 2016

An increase in expected default ratios naturally reduces prices for corporate bonds. However, it also triggers feedback loops. First, it reduces funds’ wealth and demand for corporate credit in terms of notional, resulting in selling for rebalancing purposes. Second, negative performance of funds typically triggers investor outflows, resulting in selling for redemption purposes. Flow-sensitive market-making and momentum trading can aggravate these price dynamics. A larger market share of passive funds can increase tail risks.

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The threat from China’s shadow finance

August 27, 2016

In past years China witnessed a boom in shadow finance, particularly in form of entrusted loans. Banks apparently used shadow credit products in large size to circumvent policy restrictions and bank loan regulations. Regulatory tightening has reined in the proliferation of shadow finance since 2014, but outstanding contracts pose serious systemic risk due to the combination of high default risk and dependence on fragile wholesale funding.

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The world’s negative term premium

August 20, 2016

The term premium on the “world government bond yield” has turned decisively negative, according to BIS research. Investors have since 2014 accepted a long-term yield below expected short-term rates, rather than charging a premium on duration exposure. The compression and inversion of term premia may have been fueled by a global duration carry trade and seems to be a global phenomenon. It has coincided with increased correlation of long-term yields across developed and emerging markets.

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The importance of differentiating types of oil price shocks

August 13, 2016

To assess the consequences of an oil price shock for markets it is important to identify its type. A new method separates oil supply shocks, oil market-specific demand shocks and global growth shocks. Supply shocks have accounted for about 50% of price volatility since the mid-1980s. Oil market-specific shocks drive a wedge between the growth of developed and emerging economies and hence matter for exchange rate trends. Global demand shocks to oil prices do not cause such a divergence.

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Fed policy shocks and foreign currency risk premia

August 5, 2016

A new Federal Reserve paper suggests that non-conventional monetary policy easing “shocks” not only push foreign currencies higher versus the U.S. dollar, but also reduce the risk premia on foreign-currency cash and bonds. Non-conventional easing shifts the options-implied skewness of risk from dollar appreciation to depreciation, due partly to diminishing U.S. dollar funding pressure. The effects appear to be temporary, though.

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The side-effects of non-conventional monetary policy

July 30, 2016

A BIS summary of research gives a nice overview on non-conventional monetary policies and their unintended systemic consequences. Current policies appear to yield diminishing returns in terms of easier financial conditions, while their costs and side effects are increasing. This leaves markets more exposed to future negative shocks. Also, the descent into negative nominal interest rates is itself a drag on profitability and health of the financial system that erodes the effectiveness of non-conventional policies.

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