Crashes in safe asset markets

August 5, 2022

A new theoretical paper illustrates the logic behind runs and crashes in modern safe asset markets. Safe assets are characterized by stable value and high liquidity. In times of distress “flight for safety” increases demand for these assets, while “dash for cash” increases supply. However, these two are not generally in balance. If the need for liquidity is expected to dominate and dealer balance sheets are constrained by inventory and regulation, investors have an incentive to liquidate safe assets pre-emptively to avoid outsized mark-to-market drawdowns. Put simply, concerns over liquidity and dealer balance sheets are self-fulfilling. Without government intervention they can escalate into runs and render a safe asset market dysfunctional. This dynamic was illustrated by the U.S. Treasury market sell-off in the first quarter of 2020.

(more…)

Modern financial system risk for macro trading

June 27, 2020

Financial system risk is the main constraint and disruptor of macro trading strategies. There are four key areas of modern systemic risk. [1] In the regulated banking sector vulnerability arises from high leverage and dependence on funding conditions. The regulatory reform of the 2010s has boosted capital ratios and liquidity safeguards. However, it has also induced new hazards, such as accumulation of sovereign risk, incentives for regulatory arbitrage, and risk concentration on central clearing counterparties. [2] Shadow banking summarizes financial intermediation outside the reach of standard regulation. It channels cash pools to the funding of asset holdings. Vulnerability arises from dependence on the market value of collateral and the absence of bank backstops. [3] Institutional asset management has grown rapidly in past decades and is now comparable in size to regulated banking. Asset managers play a vital role in global funding conditions but are prone to aggravating self-reinforcing market momentum. [4] Finally, emerging market financial systems have grown in size and complexity. China constitutes a global systemic risk factor due to the aggressive use of financial repression to sustain high levels of leverage and investment.

(more…)

Unproductive debt

January 4, 2020

Credit and related interest income have historically been viewed as service and related payment for lending productively. However, in a highly collateralized and risk-averse financial system credit may be granted mainly on the basis of collateral value and aim at wealth extraction rather than wealth creation. On the macroeconomic level, this creates unproductive debt, i.e. debt that is not backed by productive investment. This type of debt carries greater systemic default risk. The rapid increase of debt and leverage after the great financial crisis may be an indication of an unproductive debt problem. For the purpose of macro trading, relevant systemic risk indicators should feature intelligent debt-to-GDP ratios and trackers of collateral values.

(more…)

The dollar as barometer for credit market risk

March 9, 2019

The external value of the USD has become a key factor of U.S. and global credit conditions. This reflects the surge in global USD-denominated debt in conjunction with the growing importance of mutual funds as the ultimate source of loan financing. There is empirical evidence that USD strength has been correlated with credit tightening by U.S. banks. There is also evidence that this tightening arises from deteriorating secondary market conditions for U.S. corporate loans, which, in turn, are related to outflows of credit funds after USD appreciation. The outflows are a rational response to the negative balance sheet effect of a strong dollar on EM corporates in particular. One upshot is that the dollar exchange rate has become an important early indicator for credit market conditions.

(more…)

How convenience yields have compressed real interest rates

November 3, 2018

Real interest rates on ‘safe’ assets such as high-quality government bonds had been stationary around 2% for more than a century until the 1980s. Since then they have witnessed an unprecedented global decline, with most developed markets converging on the U.S. market trend. There is evidence that this trend decline and convergence of real rates has been due prominently to rising convenience yields of safe assets, i.e. greater willingness to pay up for  safety and liquidity. This finding resonates with the historic surge in official foreign exchange reserves, the rising demand for high-quality liquid assets for securitized transactions and the preferential treatment of government bonds in capital and liquidity regulation (view previous post here).

(more…)

How regulatory reform shapes the financial cycle

October 20, 2018

Ambitious regulatory reform has changed the dynamics of the global financial system. Capital ratios of banks have increased significantly, reining in bank credit. Counter-cyclical bank capital rules slow credit expansions by design and yield greater influence to non-banks. Meanwhile, the liquidity coverage ratio has restricted one of the key functions of banks: liquidity transformation. Regulation has also created its own moral hazards. In particular, the preferential treatment of government bonds has boosted their share in bank assets. The neglect of sovereign risk in liquidity regulation constitutes a significant systemic risk as public debt-to-GDP ratios are at or near record highs in many key economies.

(more…)

Low rates troubles for insurances and pension funds

July 14, 2018

A CGFS report highlights the pressure of a ‘low for long’ interest rate environment on life insurance companies and defined-benefit pension funds. This pressure reflects a fundamental mismatch: the duration of liabilities is greater than that of assets. Hence low rates (discount factors) have reduced funding ratios below 100% after the great financial crisis. Simulations suggest that funding ratios could decline further, possibly accompanied by negative net cash flows. A ‘low-for-long’ scenario would broadly make things worse. While the nature of this risk is well known, its manifestation is gradual and partly mitigated by the asset reflation of the 2010s. The worst scenario for insurance companies and pension funds is one where rates ultimately fail to rise or are pushed even lower (negative) due to new deflationary financial market shocks.

(more…)

Understanding collateral runs

April 14, 2018

In normal financial runs lenders want their money back. In collateral runs borrowers want their collateral back. In today’s highly collateralized financial system the institutions at risk are broker-dealers that lend and borrow cash in secured transactions and that use part of that liquidity to fund their own asset holdings. In collateral runs cash borrowers, such as hedge funds, have an incentive to rush to repay secured loans as soon as the liquidity of a broker-dealer is being questioned. That is because haircuts keep collateral value above loan notional. The demise of Bear Sterns in 2008 illustrates that the peril of collateral runs is real. Still, this source of liquidity risk has not been well explored.

(more…)

Modern financial system leverage

March 24, 2018

Leverage in modern financial systems arises from bank balance sheets and off-balance sheet transactions that involve banks and other financial institution. Non-bank funding of banks and credit is large, rising, and not fully captured in official statistics. Collateralized transactions and wealth management products are important underappreciated parts of system leverage. The classic narrow focus on bank credit-to-GDP ratios does not only underestimate leverage in size, but also overestimates the stability of sources of funding.

(more…)

The consequences of increased financial collateralization

November 18, 2017

There has been a strong upward trend in collateralization since the great financial crisis. Suitable collateral, such as government bonds, is essential for financial transactions, particularly repurchase agreements and derivative contracts. Increased collateralization poses new risks. Collateral prices and haircuts are pro-cyclical, which means that collateralized transactions flourish when assets values rise and slump when asset values decline. This creates links between leverage, asset prices, hedging costs and liquidity across many markets. Trends are mutually reinforcing and can escalate into fire sales and market paralysis. Central clearing cannot eliminate this escalation risk. The collateral policies of central banks have become more important.

(more…)

Tags

Tags
asset management Asset Purchase Program banks bond returns bond yields bubbles capital regulation central counterparty clearing China collateral commodities credit returns default ECB economic data EM equity returns euro area crisis Fed financial crisis FX FX interventions FX returns government debt government deficits herding inflation information insurances Japan leverage liquidity machine learning market turmoil price factors regulation risk management shadow banking statistical methods term structure trend following variance risk premium VIX volatility ZLB
ABOUT US

Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for over eighteen years. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.

FOLLOW US
Linkedin
LEGAL
Research
Quantamental Academy
About Us