Monetary financing does not preclude sovereign default

June 27, 2013

Most investors take for granted that a government with access to monetary financing cannot be driven to default. However, a new paper by Corsetti and Dedola challenges this belief. Monetary financing incurs costs and, hence, preference for default and self-fulfilling confidence crises are possible. Necessary conditions to rule out self-fulfilling crises include credible caps on government borrowing rates, the ability of the central bank to issue default-free, interest-bearing, and non-inflationary “reserves” (rather than cash), and full coverage of central bank losses by the state budget.

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Self-fulfilling tightening and recessions in a low interest rate world

June 23, 2013

A new Bank of England paper points to a dangerous pitfall for monetary policy in a low rates environment. “Speed-limit rules” stipulate that central banks adjust policies in accordance with the change in the economy (e.g. growth, the unemployment rate, or inflation), not its level, in order to avoid policy errors and anchor expectations. At the zero bound these rules can lead to self-fulfilling recessions, as a downshift in (growth and inflation) expectations triggers less hope for policy easing than fears for subsequent tightening (when the initial downshift is being reversed). In my view this dovetails recurrent fears of convexity or jump risk in low-yield bond markets, and may help explaining why global central banks at the zero bound have so far struggled to produce sustained recoveries.

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The structural rise in cross-asset correlation

June 20, 2013

Cross-asset correlation has remained high in recent years, despite the post-crisis decrease in volatility. Typically, correlation surges during financial crises, when macro risk factors dominate across markets. However, J.P. Morgan’s Marko Kolanovic and Bram Kaplan show that there has also been a secular increase in cross-asset correlation since 1990, due probably to globalization of markets, risk management and alpha generation techniques.

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Overshooting of U.S. Treasury yields

June 17, 2013

The U.S. rates research team of Bank of America/Merrill Lynch reasons that fears of less accommodative monetary policy can trigger a rise in U.S. Treasury yields that goes beyond the rationally expected path in fed funds rates. Catalysts of such non-fundamental dynamics can be (i) increased mortgage convexity risk, (ii) spillovers and repercussions from other bond markets, and (iii) duration hedging in the wake of bond fund outflows. Thereby, large institutional flows in a market with few players to warehouse risk can lead to an overshooting of yields.

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China’s augmented fiscal challenge

June 15, 2013

A very short note by the IMF in the run-up of China’s latest Article IV consultations suggests that the country’s fiscal position is much weaker than official statistics suggest. The augmented fiscal deficit of the country, including local government off-budget funding, is estimated to have climbed to around 10% of GDP.

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On “institutional herding”

June 14, 2013

Herding denotes broad uniformity of buying and selling across investors. If the transactions of one institution encourage or reinforce those of another, escalatory dynamics, liquidity problems, and pricing inefficiencies ensue. A Federal Reserve paper (which I noticed belatedly) provides evidence of herding in the U.S. corporate credit market during the 2003-08 boom-bust experience, particularly during sell-offs. Bond herding seems to be stronger than equity herding. Subsequent to herding dynamics price reversals have been prevalent, consistent with the idea of temporary price distortions.

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The limited effect of FX interventions

June 13, 2013

In a new BIS paper K. Miyajima provides evidence that unsterilized FX interventions in emerging market economies fail to influence exchange rate forecasts (as published by Consensus Economics) in the direction of the intervention. This supports the intuition of market practitioners that interventions may briefly stem or reverse the market tide, but do not typically have the purpose or power to change the prevailing fundamental trend.

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The “reach for yield” bias of institutional investors

June 5, 2013

‘Reach for yield’ describes regulated investors’ preference for high-risk assets within the confines of a rule-based risk metric (such as credit ratings or VaR). Bo Becker and Victoria Ivashina provide evidence that U.S. insurance companies act on this principle and show that ”conditional on ratings, insurance portfolios are systematically biased toward higher yield bonds”. ‘Reach for yield’ would be a form of regulatory arbitrage, a source of inefficiency, and a reward for “unaccounted risk” of securities and issuers.

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Measuring diversification and downside risk

June 1, 2013

Deutsche Bank’s Handbook of Portfolio Construction gives a great introduction to two important principles for diversification and risk management of portfolios. First, tail dependence is a better guide to diversification than correlation when it really matters, i.e. in market turmoil. Second, conditional Value-at-Risk concepts (CVaR) estimates average losses one may sustain in an extreme event, and hence should be more representative for true downside risk than standard VaR. Backtests suggest that portfolio construction based on these and other risk measures produces signficant investor value.

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China’s commodity financing deals

May 27, 2013

Chinese commodity financing deals exemplify how regulation and circumvention can distort more than one major market. These transactions have been a means for circumventing capital controls and facilitated short USD-CNY carry trades. Thereby they generated capital inflows into China, and distorted demand for physical metals (particularly copper) vis-a-vis futures. As China’s State Administration of Foreign Exchange (SAFE) has issued new regulation to curb these transactions, rapid unwinding might cause reverse distortions.

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