The demographic compression of interest rates

August 5, 2017

Declining population growth and rising dependency ratios in the developed world have been one key factor behind the decline in nominal and real interest rates since the 1980s. Personal savings for retirement are growing, while investment spending is not rising commensurately, and long-term economic growth is dampened by slowing or even shrinking work forces. A new ECB paper suggests that for the euro area these trends will likely continue to compress interest rates for another 10 years, a challenge for monetary policy and financial stability.

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The global effects of a U.S. term premium shock

April 22, 2017

Empirical research suggests that shocks to U.S. treasury term premia have had a persistent subsequent impact on term premia in other developed and emerging fixed income markets. Global financial integration and inflation seem to increase the sensitivity of non-U.S. markets. A 200bps rise in the U.S. premium from current compressed levels could boost the term premia in other countries between 50 and 175 basis points. Hence, a U.S. shift towards reflationary policies or greater net supply of long-term treasuries could greatly increase borrowing costs around the world, exposing weaknesses in overleveraged economies and sectors.

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Watching U.S. financial conditions

April 15, 2017

The U.S. financial system wields dominant influence over the national and global economies. Moreover, securities and derivatives markets play a greater role relative to banks and compared to other developed countries. Medium-term shifts in financial conditions, rather than short-term changes, should be consequential for economic growth and monetary policy. Therefore, a timely and consistent measurement of U.S. financial conditions is crucial for macro trading strategies. A broad econometric measure of U.S. financial conditions based on risk, liquidity and leverage is produced and regularly updated by the Chicago Fed.

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Measuring non-conventional monetary policy surprises

March 18, 2017

A new paper proposes a measure for monetary policy surprises that arise from asset purchases and forward guidance. The idea is to estimate the change in the first principal component of government bond yields at different maturities to the extent that it is independent of changes in the policy reference rate and on days of significant policy statements. Such identified non-conventional policy shocks have had a persistent impact on yield curves and exchange rates since 2000. Their monitoring is important for so-called “long-long” risk parity trades.

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Inflation: risk without premium

December 31, 2016

Historically, securities that lose value as inflation increases have paid a sizable risk premium. However, there is evidence that inflation risk premia have vanished or become negative in recent years. Macroeconomic theory suggests that this is related to monetary policy constraints at the zero lower bound: demand shocks are harder to contain and cause positive correlation between inflation and growth. Assets whose returns go down with higher inflation become valuable proxy-hedges. As a consequence, inflation breakevens underestimate inflation. Bond yields would rise disproportionately once policy rates move away from the zero lower bound.

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Term premia in the times of “lift-off”

November 12, 2016

Equilibrium models suggest that as long as the policy rate is firmly near zero, the term premium on longer-dated yields is compressed by a reduced sensitivity of rates to economic change. However, when policy rates are on the move again this sensitivity recovers, while proximity of the zero lower bound implies high economic risks and a surcharge on the term premia. Hence, term premium uncertainty would be highest at the time of “lift-off”, when policy rates are expected to move upward from near zero.

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Japan’s yield curve control: the basics

October 8, 2016

The Bank of Japan has once again broken new grounds in monetary policy, now targeting not just the short-term policy rate but – within limits – the 10-year JGB yield. In practice the Bank will secure a positive yield curve against the backdrop of negative short-term rates and negative expected long-term real rates. This is meant to mitigate the debilitating effect of yield compression on the financial system and, probably, to contain the risk of bond yield tantrums in case domestic spending and inflation do pick up. As a side effect, the policy would subsidize long duration carry trades and long-long equity-duration risk parity positions.

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ECB asset purchases: the three transmission channels

September 24, 2016

A new paper suggests that ECB asset purchases influence markets and the economy significantly, mainly through three channels. First, through the asset valuation channel they reduce risk premia and provide capital relief to leveraged institutions, particularly banks. Second, through the signalling channel they enhance the credibility of rates staying low for long. Third, through the re-anchoring channel, asset purchases can reassure the private sector that the central bank remains committed to its long-term inflation target.

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The world’s negative term premium

August 20, 2016

The term premium on the “world government bond yield” has turned decisively negative, according to BIS research. Investors have since 2014 accepted a long-term yield below expected short-term rates, rather than charging a premium on duration exposure. The compression and inversion of term premia may have been fueled by a global duration carry trade and seems to be a global phenomenon. It has coincided with increased correlation of long-term yields across developed and emerging markets.

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The side-effects of non-conventional monetary policy

July 30, 2016

A BIS summary of research gives a nice overview on non-conventional monetary policies and their unintended systemic consequences. Current policies appear to yield diminishing returns in terms of easier financial conditions, while their costs and side effects are increasing. This leaves markets more exposed to future negative shocks. Also, the descent into negative nominal interest rates is itself a drag on profitability and health of the financial system that erodes the effectiveness of non-conventional policies.

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