A new empirical study suggests that the Federal Reserve has exerted a stronger influence on fixed income, commodity, and currency markets since it started using non-conventional monetary policy. This is not because monetary policy shocks have been larger, but because their transmission has become more powerful and pervasive.
A working paper explores sources of market price trends. It suggests that small trend changes in perceptions about “fundamentals” can set in motion a persistent adjustment in transacted prices. And even without any changes to “fundamentals” or “technicals” trends are plausible.
Christopher Cole argues that volatility markets are about trading both known and unknown risks. These risks require different pricing and cause different “crashes”. Most portfolio managers either hold implicit short volatility or long volatility positions. After the great financial crisis, monetary policy has suppressed volatility, but steep volatility curves are indicating a “bull market in fear”.
Brunnermeier and Sannikov illustrate in a formal model why fundamental risk and asset market volatility can be out of sync. They focus on endogenous market dynamics, such as “collateral amplification” (the mutual reinforcement of credit conditions and asset values). These endogenous dynamics imply that [i] low-risk environments foster systemic risk, [ii] market reactions to negative fundamental shocks are non-linear (i.e. can become catastrophic when the shock is large) and [iii] financial market risk can de-couple from fundamental risk.
John Coates gives a neuroscience view on how human “stress response” can aggravate financial crises. Rising market volatility causes a bodily response in form of a sustained elevation of the stress hormone cortisol in traders and investors. This raises risk aversion and may contribute to institutional paralysis. Central banks’ policies aimed at keeping markets calm in normal times may weaken traders’ immune system.
Regulators and financial institutions rely on statistical models to assess market risk. Alas, a new Federal Reserve paper shows that risk models are prone to creating confusion when they are needed most: in financial crises. Acceptable performance and convergence of risk models in normal times can lull the financial system into a false sense of reliability that transforms into model divergence and disarray when troubles arise.
Uncovered equity parity explains how equity portfolio rebalancing affects exchange rates. Outperformance of foreign stock markets, whether through the exchange rate or stock prices, leaves investors with excess exchange rate exposure. The reduction of this exposure then puts depreciation pressure on the foreign currency. A new Federal Reserve paper presents evidence for the essential parts of that theory.
An updated paper by Adam, Beutel, and Marcet claims that booms and busts in U.S. stock prices can be explained by investors’ subjective capital gains expectations. Survey measures of these expectations display excessive optimism at market peaks and excessive pessimism at market troughs.
A new paper from the ETH Zurich defines bubbles as episodes of unsustainable and quickening asset price growth with accelerating corrections and rebounds. In order to recognize such patterns it is critical to focus on the broader picture and correct time scale, rather than concurrent detail. Bubbles arise from innovations, valuation uncertainty and various positive feedback mechanisms that make prices spiral away from equilibrium. A critical state is often indicated by asset prices growing faster than exponentially.
Bank of England’s Andrew Haldane has summarized the rise and risks of asset management in a recent speech. As demographics and economic development propel the industry to ever higher assets under management, self-reinforcing correlated dynamics become a greater systemic concern. Market conventions, accounting practices, regulatory changes and structural changes in the industry all contribute to this risk.
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.
