Some stylized facts of FX liquidity

October 28, 2013

A paper of the University of St. Gallen shows that foreign exchange liquidity has been highly correlated across currency pairs, apparently more so than in equity markets. Liquidity correlation has been strongest in developed FX markets and particularly in volatile currency pairs. Bond and equity markets seem to have a bearing on systematic FX liquidity. Feedback loops between market illiquidity and funding constraints can escalate into fire sales. Riskier currency pairs, and particularly those related to carry trades, are more susceptible to liquidity shocks.

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Liquidity regulation and monetary policy

October 24, 2013

From 2015 banks will have to satisfy new liquidity standards. Of particular importance is the liquidity coverage ratio, which requires institutions to hold enough “high quality liquid assets” to withstand a 30-day period of funding stress. This will complicate the conduct of monetary policy and affect short-term yield curves, which will probably price some regulatory term premium.

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A theory of safe asset shortage

October 21, 2013

Ricardo Caballero and Emmanuel Farhi from MIT and Harvard propose an interesting and relevant formal model of safe asset shortage. While safe asset supply is constrained by the fiscal capacity of sovereigns and financial innovation, demand may be in a secular ascent (driven for example by collateralization and population aging). The resulting shortfall can result in a structural drag on economic growth and impair the effectiveness of fiscal and monetary policies, with some resemblance to the Keynesian liquidity trap.

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Dealer balance sheets and market liquidity

October 17, 2013

Even in a huge market like U.S. fixed income, dealer balance sheet management these days can impair liquidity. New Federal Reserve research suggests that during the 2013 treasury sell-off dealers reduced their own positions rather than absorbing client flows and decided to limit their market making.

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Unconventional monetary policy: impact and exit problems

October 15, 2013

According to a new IMF report, unconventional monetary policies succeeded in stabilizing financial markets and lowering sovereign yields. Since protracted accommodation would invite excessive duration risk taking, the design of exit is becoming more important. Tightening may occur first through forward guidance or even rate hikes, before the vast outstanding excess reserves can be reduced back towards pre-crisis levels. This could imply greater volatility of interest rates, due to limited control of central banks over short rates and great uncertainty about the impact of tapered and reversed purchase programs on long–term yields.

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The world’s fiscal outlook

October 11, 2013

The IMF projects that 2013 will see a big reduction in the developed world’s fiscal deficit by roughly 1.5%-points to 4.5% of GDP. By now the majority of highly-indebt countries seems to have achieved about two-thirds of the required post-crisis fiscal consolidation. The advanced countries’ public debt stock remains elevated at 109% of GDP, however, leaving the world vulnerable to higher interest rates and sovereign solvency risks.

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The rising global savings glut

October 9, 2013

A DB paper suggests that the rising median age of the world’s population will increase savings ratios. The trend is reinforced by macro policies aimed at generating external surpluses or at least restraining deficits. The onus of absorbing the resulting savings glut may fall on the United States, which issues the world’s anchor currency. Irrespective of whether it accepts that role, cost of capital for the world as a whole is likely to be compressed by the savings glut.

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Side effects of capital regulation reform

October 5, 2013

Capital regulation reform could lead to excessive bank asset encumbrance and distortions in funding markets, as unsecured institutional creditors face an increased risk of statutory bail-in. Excessive asset encumbrance could undermine a bank’s resolution in distress. Rising costs of unsecured bank debt could lower its share below what is required for loss absorption.

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The U.S. Fed’s new tools to control short-term rates

October 3, 2013

A Federal Reserve paper describes and evaluates monetary policy tools for managing short-term market rates in an environment of large-scale excess reserve money in the financial system. These tools are interest on excess reserves (IOER), reverse repurchase agreements (RRPs) with a wide range of market participants, and the term deposit facility (TDF).

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The case for monitoring shadow banking risks

October 1, 2013

Another Federal Reserve paper on shadow banking emphasizes its systemic risks. In particular, shadow banking seems to have a tendency to accumulate tail risks, relies on fragile funding conditions (without official backstop), and is subject to pronounced pro-cyclicality. Shadow banking activity is tied to core regulated institutions and, hence, is a valid concern for broad financial stability.

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