There are signs of liquidity decline and liquidity illusion in euro area government bond markets. Citibank research suggests that liquidity risk is rising due to increased capital requirements for dealers, reduced market maker inventories, enhanced dealer transparency rules, elevated assets under management of bond funds, and the liquidity transformation provided by these funds.
A 145-year empirical analysis suggests that asset price surges are most dangerous when they are associated with rising financial leverage. The combination of housing price bubbles and credit booms has been the most detrimental of all. This bodes ill for modern leveraged housing price booms, such as in China.
A new IMF paper provides evidence that increased foreign participation in local-currency emerging debt markets has made these significantly more vulnerable to foreign interest rate and risk shocks. Concentration of the investor base and poor economic fundamentals appear to amplify such vulnerability.
The BIS annual report emphasizes the dollar’s pervasive influence on international financial conditions. Post-crisis non-conventional Fed easing has spurred a global credit expansion, including economies that did not need it. Conversely, Fed tightening would reverse easy financing on a global scale, including countries that are ill prepared for it. FX depreciation is unlikely to insulate small and emerging economies from credit tightening.
A new ECB paper explores macroeconomic indicators for banking and currency crises over the past 40 years. Banking crises arose mostly in constellations of [i] low credit-deposit spreads and high short-term rates (over 11%) or [iii] high credit-deposit spreads (over 270 bps) and flat or inverted yield curves. Housing price growth has also been a warning signal. Currency crises ensued from exchange rate overvaluation (more 2.7% above trend) and high short-term interest rates (over 10%).
The shadow banking system creates money or money-like claims mainly through repurchase operations: cash managers “park” funds through short-term secured lending, while asset managers borrow against their securities to gain leverage. Large institutions have few alternatives to collateralized lending for cash management. Institutional cash pools and “shadow money” have been expanding rapidly over the past decade.
The non-bank financial sector in the euro area has doubled in size over the last 10 years. It has become a concern for three reasons. First, its tight links with regulated banks imply contagion risk. Second, investment funds’ supply of liquidity has become critical for many markets, but is pro-cyclical. And third, rising synthetic leverage aggravates pro-cyclicality of both market prices and liquidity conditions.
A new CGFS paper suggests that bank regulatory capital and liquidity changes may [i] reduce liquidity in money markets, [ii] create steeper short-term yield curves, [iii] weaken bank arbitrage activity, and [iv] increase reliance on central bank intermediation. Profit opportunities may arise for non-banks.
Negative nominal interest rates and term premia are an issue for financial stability in Europe, according to a recent speech by the Deputy General Manager of the BIS. Duration risk has surged and banks’ exposure to sovereign credit and long-term rates has been compounded by flawed capital regulation. Governments find it easier to live with high debt levels for now, but at the expense of a weaker financial position of insurance companies and pension funds.
The new European insurance regulation will be introduced in 2016 with important consequences for the global financial system. A paper by Avinash Persaud argues that Solvency II introduces an undue bias against assets with high market and liquidity risk, such as equity. Meanwhile it encourages excessive holdings of low-yielding sovereign and high-grade bonds. (more…)
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 two decades. 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.
