Two recent papers contribute to forecasting inflation in a world of convergent policy regimes and integrated economies. The first emphasizes the distinct effects of shocks to aggregate demand, supply, and monetary policy. The second explains why country inflation usually corrects deviations from trends in the rest of the world. Predominantly inflation has become a global force.
Empirical analyses document the success of trend following strategies in global equity and FX markets over the past 30 years. Stylized trend following delivered higher risk-adjusted returns with smaller maximum drawdowns when compared with other conventional strategies. It also provided value as a hedging strategy.
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.
A BOJ paper proposes an affine terms structure model for bond yields under consideration of the zero lower bound. It estimates the contribution of [i] expected real rates, [ii] real term premia, [iii] expected inflation rates, and [iv] inflation risk premia. In the U.S. yields have been driven mainly by expected real rates and real term premia in recent years. In Japan inflation expectations and inflation/deflation risk premia have played a greater role.
A new BIS paper provides important lessons for EMFX carry trades, using Latin America as a case study. First, FX carry opportunities depend on market structure and regulation. Second, observed carry typically contains a classic interest rate differential and an arbitrage premium that reflects the state of on-shore and off-shore markets. Third, liquidity shortages and FX proxy hedging constitute major setback risks.
Over the past 25 years the relation between implied equity volatility (VIX) and market returns has been non-linear. When VIX was low there was no meaningful relation. However, when volatility increased above average higher equity and lower bond returns followed. This is evidence for “flight to quality“, where investors pay a rising premium for safe and liquid assets as volatility increases. Fear of redemptions, liquidity constraints, and deteriorating market intermediation are plausible causes of this effect.
The variance risk premium is paid by risk-averse investors to hedge against variations in future realized volatility. Empirical evidence and intuition suggest that equity markets indeed pay over the odds for downside risk in mark-to-market variations but accept a discount for upside risk. The highest premium is paid for downside skewness risk. These forms of variance risk premia have been significant predictors of U.S. equity returns.
A new BIS paper summarizes motives and impact of FX interventions. Most importantly it looks at the conditions under which such interventions are effective (and hence likely). The strongest case for interventions arises when [i] the central bank has a clear view about an exchange rate misalignment, and [ii] the intervention would not go against the interest rate differential.
An empirical study shows that U.S. mutual funds take two major allocation decisions: bonds versus equity and U.S. versus non-U.S. assets. Federal Reserve policy easing encourages shifts into foreign assets. High uncertainty drives allocations out of risky assets into U.S. treasuries. And the relative performance of foreign versus U.S. assets leads a chase of the higher return. Within fixed income institutions tend to reallocate gradually towards higher prior yields.
A Bank of England paper integrates commodity futures with bond yield curves. It finds that bond factors exert significant influence on commodities. It also finds that risk premia paid in crude oil futures have shifted over the decades from negative to positive, as crude’s hedge value faded with the memory of the oil crises. Gold futures have long paid a positive risk premium for lack of empirical hedge value.
