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.
A new IJCB article shows that historically [i] inflation expectations had a strong impact on long-term yields and [ii] economic data surprises had a strong impact on inflation expectations. However, the influence of compensation for inflation and inflation risk on U.S. bond yields has faded in the era of non-conventional monetary policy.
Herding arises from deliberate decisions of informed traders to follow others. It can create inefficiency, dislocations and, hence, profit opportunities. A paper by German academics suggests that herding is the more intense the better informed the market is and the greater the information risk. The paper also finds that both sell-herding and buy-herding increased during the last financial crisis.
A paper by Greenwald, Lettau, and Ludvigson argues that short-term (quarterly) equity price fluctuation arise mainly from changes in risk aversion, while long-term trends (over decades) are heavily influenced by reallocation from labor to capital income. The latter appears to explain all the stock market gains in the U.S. since 1980.
Assessing the risk of equity market “crashes”, academic work has focused on price-earnings ratios and bond-stock earnings yield differentials. A recent paper by Lleo and Ziemba provides theoretical reasoning and empirical support for these warning signs.
As risk perceptions and risk aversion are fluctuating overtime, so should equity premia. This is a basis for the predictability of equity returns, even in an efficient market. A new Bank of England paper provides evidence that equity returns are indeed predictable by using two classical frameworks: the dividend discount model and multi-indicator vector autoregression.
Exchange rates are pulled about by countless factors. There is a tendency to focus on standard fundamentals that happened to coincide with recent exchange rate moves. This has given rise to the “scapegoat theory of exchange rates”. It is nicely explained in a recent Bank of Italy paper. It implies caution in respect to popular “FX themes” in broker research that may lead to distortions, crowded positions and setback risk.
Simple regression is inadequate for predicting bond returns, as the character of rates markets changes fundamentally with economic conditions. In financial modelling terms this calls for time-varying parameters, time-varying volatility, and model uncertainty. A CEPR paper claims that these features can help turning standard forecast factors (forward rates, forward spreads, and macro) into a valuable prediction model.
A BIS paper shows significant positive correlation of implied FX volatility and local EM bond yields. Empirically the causality runs mostly from FX to bonds, probably because currency risk is a key factor of foreign bond holdings. However, there can also be reverse causality, when FX derivatives are used as proxy hedge in a bond market turmoil. Since FX volatility is stationary, extreme values can indicate value in local EM bonds.
Market liquidity measures the cost efficiency of trading. Liquidity risk refers to the probability that these costs surge when trading is required. Liquidity and liquidity risk are major factors in the long-term performance of trading strategies. The apparent inverse relation between liquidity and expected returns also offers obvious profit opportunities. There are various conceptual solutions for measuring market liquidity timely.
