Even in a huge market like U.S. fixed income, dealer balance sheet management these days can impair liquidity. New Federal Reserve research suggests that during the 2013 treasury sell-off dealers reduced their own positions rather than absorbing client flows and decided to limit their market making.
According to a new IMF report, unconventional monetary policies succeeded in stabilizing financial markets and lowering sovereign yields. Since protracted accommodation would invite excessive duration risk taking, the design of exit is becoming more important. Tightening may occur first through forward guidance or even rate hikes, before the vast outstanding excess reserves can be reduced back towards pre-crisis levels. This could imply greater volatility of interest rates, due to limited control of central banks over short rates and great uncertainty about the impact of tapered and reversed purchase programs on long–term yields.
The IMF projects that 2013 will see a big reduction in the developed world’s fiscal deficit by roughly 1.5%-points to 4.5% of GDP. By now the majority of highly-indebt countries seems to have achieved about two-thirds of the required post-crisis fiscal consolidation. The advanced countries’ public debt stock remains elevated at 109% of GDP, however, leaving the world vulnerable to higher interest rates and sovereign solvency risks.
A DB paper suggests that the rising median age of the world’s population will increase savings ratios. The trend is reinforced by macro policies aimed at generating external surpluses or at least restraining deficits. The onus of absorbing the resulting savings glut may fall on the United States, which issues the world’s anchor currency. Irrespective of whether it accepts that role, cost of capital for the world as a whole is likely to be compressed by the savings glut.
Capital regulation reform could lead to excessive bank asset encumbrance and distortions in funding markets, as unsecured institutional creditors face an increased risk of statutory bail-in. Excessive asset encumbrance could undermine a bank’s resolution in distress. Rising costs of unsecured bank debt could lower its share below what is required for loss absorption.
Another Federal Reserve paper on shadow banking emphasizes its systemic risks. In particular, shadow banking seems to have a tendency to accumulate tail risks, relies on fragile funding conditions (without official backstop), and is subject to pronounced pro-cyclicality. Shadow banking activity is tied to core regulated institutions and, hence, is a valid concern for broad financial stability.
A Nomura research report suggests that China’s local government financing vehicles now pose a major risk for the economy. Their debt stock has surged close to 40% of GDP over the past three years. Profitability is poor, liquidity risks are high, and solvency hinges on government support.
Target2 is the real-time gross settlement system of the Eurosystem. It allows central banks to redress reserve losses that result from balance of payment deficits. A working paper of the University of Siena illustrates how Target2 prevented the euro area sovereign crisis from escalating into large-scale defaults and devaluations. Limitations to Target2 could downgrade the monetary union to a fixed exchange rate regime, if international flows become large enough.
The OTC derivatives reform is nearing completion. It is designed to contain derivatives-related credit and contagion risk through standardization, multilateral netting, and adequate collateralization. However, new risks may arise, due to the enhanced importance of a small group of global banks, institutional weaknesses of central counterparties, limited collateral availability, and cyclicality of margins,
A new IMF paper suggests that so-called “long-term institutional investors” have largely turned pro-cyclical in recent crises. This feature may be structural and reflect (a) underestimation of liquidity needs in boom times, (b) failure of traditional risk management systems to appreciate tail risk, (c) asset managers’ short-term performance targets, (d) links between short-term performance disclosures and asset outflows, and (e) regulations and conventions that encourage herding.
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.
