Overshooting of U.S. Treasury yields

June 17, 2013

The U.S. rates research team of Bank of America/Merrill Lynch reasons that fears of less accommodative monetary policy can trigger a rise in U.S. Treasury yields that goes beyond the rationally expected path in fed funds rates. Catalysts of such non-fundamental dynamics can be (i) increased mortgage convexity risk, (ii) spillovers and repercussions from other bond markets, and (iii) duration hedging in the wake of bond fund outflows. Thereby, large institutional flows in a market with few players to warehouse risk can lead to an overshooting of yields.

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On “institutional herding”

June 14, 2013

Herding denotes broad uniformity of buying and selling across investors. If the transactions of one institution encourage or reinforce those of another, escalatory dynamics, liquidity problems, and pricing inefficiencies ensue. A Federal Reserve paper (which I noticed belatedly) provides evidence of herding in the U.S. corporate credit market during the 2003-08 boom-bust experience, particularly during sell-offs. Bond herding seems to be stronger than equity herding. Subsequent to herding dynamics price reversals have been prevalent, consistent with the idea of temporary price distortions.

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The limited effect of FX interventions

June 13, 2013

In a new BIS paper K. Miyajima provides evidence that unsterilized FX interventions in emerging market economies fail to influence exchange rate forecasts (as published by Consensus Economics) in the direction of the intervention. This supports the intuition of market practitioners that interventions may briefly stem or reverse the market tide, but do not typically have the purpose or power to change the prevailing fundamental trend.

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Measuring diversification and downside risk

June 1, 2013

Deutsche Bank’s Handbook of Portfolio Construction gives a great introduction to two important principles for diversification and risk management of portfolios. First, tail dependence is a better guide to diversification than correlation when it really matters, i.e. in market turmoil. Second, conditional Value-at-Risk concepts (CVaR) estimates average losses one may sustain in an extreme event, and hence should be more representative for true downside risk than standard VaR. Backtests suggest that portfolio construction based on these and other risk measures produces signficant investor value.

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China’s commodity financing deals

May 27, 2013

Chinese commodity financing deals exemplify how regulation and circumvention can distort more than one major market. These transactions have been a means for circumventing capital controls and facilitated short USD-CNY carry trades. Thereby they generated capital inflows into China, and distorted demand for physical metals (particularly copper) vis-a-vis futures. As China’s State Administration of Foreign Exchange (SAFE) has issued new regulation to curb these transactions, rapid unwinding might cause reverse distortions.

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Improving the information value of dividend yields

April 24, 2013

Marco Dion, Viquar Shaikh and colleagues at J.P. Morgan Cazenove illustrate how the information value of equity dividend yield can be enhanced. Their measure of “shareholder yield” integrates dividends with other forms of cash returns, i.e. share buybacks and debt redemption. They present evidence that for U.S. and European stocks the enhanced measures creates alpha for systematic trading styles.

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Why and when “equity duration” matters

March 23, 2013

A new HSBC report suggests that if and when Quantitative Easing is being reversed it could be a watershed event for sectoral equity performance. Their view is based on the concept of “equity duration”. The long-standing outperformance of low-beta and high-quality stocks, which have longest duration and benefited most from three decades of falling yields, should come to an end and be replaced by relative strength of cyclical, financial and materials stocks.

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The FX carry-equity nexus

March 16, 2013

Galsband and Nitschka claim that the outperformance of high-carry currency trades over the past 30 years reflects a premium for correlation with shocks to equity cash flows. While the finding may sound trivial, its implications are important. In particular, in connection with the negative impact of currency strength on local equity, the fx carry-equity nexus would imply that carry countries’ local-currency equity returns should outperform in crisis times, as they are buffered by the exchange rate and become a better diversifier, when all other correlation increase.

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Asset overvaluation and bubbles

March 9, 2013

Ever wondered why an asset or asset class maintains an implausibly high price? A new IMF paper summarizes research on “bubbles”, the phenomenon of a lasting overvaluation. It suggests, for example, that the focus on relative performance among asset managers and the presumption of informed decisions by peers causes herding. Also, limited liability of managers and leveraged institutions encourages upside risk taking. Meanwhile, sell-side research, rating agencies, and accountants often lack the incentives to pre-emptively reveal downside risks. Political and institutional aversion to short selling aggravates overvaluation bias.

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A Fed view on low long-term yields

March 9, 2013

Federal Reserve Chairman Bernanke recently explained globally low long-term yields as a combination of anchored inflation expectations, negative real policy rates, and a compressed term premium. The latter is seen as the key development since 2010 resulting from (i) the surge in private demand in the wake of reduced nominal volatility and negative correlation with risk markets and (ii) a surge in public demand resulting from asset purchase programs and FX reserves replenishing. Bernanke emphasizes that the Fed, markets, and forecasters all expect long-term yields to drift higher by 50-75bps per year through 2017. Yet, actually his reasoning would make a sustained directional change in yields contingent on fading crisis and deflation fears.

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