The financial stability interest rate

March 6, 2021

The financial stability interest rate is a threshold above which the real interest rate in an economy triggers financial constraints and systemic instability. It is different from the natural rate of interest, which balances growth and inflation. Indeed, the relationship between the financial stability interest rate and the natural interest rate may be one of the most important predictors of medium-term market direction and future crisis risk. A low financial stability rate versus the natural rate will create a tendency for real interest rates to rise to levels that disrupt financial relations. Factors that lower the financial stability rate include leverage and asset quality in the financial system. It is possible to build time series of financial conditions and stability rates.

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Contagion and self-fulfilling dynamics

February 6, 2021

Contagion and self-fulfilling feedback loops are propagation mechanisms at the heart of systemic financial crises. Contagion refers to the deterioration of fundamentals through the financial network, often through a cascade of insolvencies. A critical factor is the similarity of assets held by financial institutions. The commonality of assets erases some of the benefits of diversification because it facilitates contagion. The potential role of investment funds in aggravating contagion through fire sales has much increased over the past 20 years. Self-fulfilling feedback loops denote the shift from one equilibrium to another, possibly without a change in ‘fundamentals’. They arise from multiple equilibria and strong interdependencies in a financial network. Bank runs are a classic example. Simple metrics that track both types of systemic risk are principal components and cross-correlation coefficients of different types of financial assets.

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Macro uncertainty as predictor of market volatility

January 23, 2021

Market volatility measures the size of variations of asset returns. Macroeconomic uncertainty measures the size of unpredictable disturbances in economic activity. Large moves in macroeconomic uncertainty are less frequent and more persistent than shifts in market volatility. However, macroeconomic uncertainty is an important driver of market volatility because it is related to future earnings and dividend discount rates. One proxy of macro uncertainty is a weighted average of forecasting errors over a wide set of macroeconomic indicators. Empirical evidence suggests that this proxy of latent macro uncertainty is a significant predictor of volatility and volatility jumps.

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Understanding international capital flows and shocks

October 3, 2020

Macro trading factors for FX must foremostly consider (gross) external investment positions. That is because modern international capital flows are mainly about financing, i.e. exchanges of money and financial assets, rather than saving, real investments and consumption (which are goods market concepts). Trades in financial assets are much larger than physical resource trades. Also, financing flows simultaneously create aggregate purchasing power, bank assets and liabilities. The vulnerability of currencies depends on gross rather than net external debt. Current account balances, which indicate current net payment flows, can be misleading. The nature and gravity of financial inflow shocks, physical saving shocks, credit shocks and – most importantly – ‘sudden stops’ all depend critically on international financing.

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Measures of market risk and uncertainty

August 8, 2020

In financial markets, risk refers to the probability distribution of future returns. Uncertainty is a broader concept that encompasses ambiguity about the parameters of this probability distribution. There are various types of measures seeking to estimate risk and uncertainty: [1] realized and derivatives-implied distributions of returns across assets, [2] news-based measures of policy and political uncertainty, [3] survey-based indicators, [4] econometric measures, and [5] ambiguity indices. The benefits for macro trading are threefold. First, uncertainty measures provide a basis for comparing the market’s assessment of risk with private information and research. Second, changes in uncertainty indicators often predict near-term flows in and out of risky asset classes. Third, the level of public and market uncertainty is indicative of risk premia offered across asset classes.

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Modern financial system risk for macro trading

June 27, 2020

Financial system risk is the main constraint and disruptor of macro trading strategies. There are four key areas of modern systemic risk. [1] In the regulated banking sector vulnerability arises from high leverage and dependence on funding conditions. The regulatory reform of the 2010s has boosted capital ratios and liquidity safeguards. However, it has also induced new hazards, such as accumulation of sovereign risk, incentives for regulatory arbitrage, and risk concentration on central clearing counterparties. [2] Shadow banking summarizes financial intermediation outside the reach of standard regulation. It channels cash pools to the funding of asset holdings. Vulnerability arises from dependence on the market value of collateral and the absence of bank backstops. [3] Institutional asset management has grown rapidly in past decades and is now comparable in size to regulated banking. Asset managers play a vital role in global funding conditions but are prone to aggravating self-reinforcing market momentum. [4] Finally, emerging market financial systems have grown in size and complexity. China constitutes a global systemic risk factor due to the aggressive use of financial repression to sustain high levels of leverage and investment.

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Public finance risk

April 25, 2020

Fiscal expansion was the logical response to the 2020 health and economic crisis. Alas, public deficit and debt ratios had already been historically high before. The IMF estimates that this year’s general government deficit in the developed world will reach 11% of GDP, while the government debt stock will exceed 120% of GDP. Fiscal sustainability relies on low or negative real interest rates. Yet, on smaller and lower-grade countries credit spreads have risen and become more volatile. In the large developed economies, central bank purchases help to absorb the glut of debt issuance but cannot prevent balance sheet deterioration. Concerns over sovereign credit risk or – more realistically – debt monetization are rational. Fiscal risk and related government strategies will likely be key drivers of financial market trends for years to come.

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Systemic risk under non-conventional monetary policy

February 15, 2020

Central bank operations in the form of quantitative easing, qualitative easing, forward guidance and collateral policies wield great influence over market prices of risk. These policies reduce market volatility by design, compromising statistical assessment of risk and fostering leverage through endogenous market dynamics, such as collateral amplification. Also, current non-conventional monetary policies become less effective with increasing use. Yields, credit spreads, and term premia all have effective lower bounds and the more they are compressed, the less incremental economic support can be provided. Yet reversing such policies is challenging since leveraged institutions become dependent on cheap funding and credit market stabilization programs. In future economic downturns, another policy regime break is likely, possibly towards monetary financing of fiscal expansion. Hence, macro trading strategies need to consider the structural change in the monetary policy response function.

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Risk management shocks and price distortions

January 18, 2020

Risk management relies on statistical metrics that converge on common standards. These metrics can change drastically alongside market conditions. A risk management shock is a large unanticipated market-wide change in statistical risk estimates. These shocks give rise to coerced or even distressed flows, typically subsequent to an initial large move in market prices. Risk management shocks and related flows can team up with other dynamics in the financial system to form feedback loops. Such reinforcing dynamics include dynamic hedging, market price-driven credit downgrades, popular fear of crisis, investment fund redemptions, and forced deleveraging. Feedback loops can trigger large and persistent price distortions and offer special trading opportunities.

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Unproductive debt

January 4, 2020

Credit and related interest income have historically been viewed as service and related payment for lending productively. However, in a highly collateralized and risk-averse financial system credit may be granted mainly on the basis of collateral value and aim at wealth extraction rather than wealth creation. On the macroeconomic level, this creates unproductive debt, i.e. debt that is not backed by productive investment. This type of debt carries greater systemic default risk. The rapid increase of debt and leverage after the great financial crisis may be an indication of an unproductive debt problem. For the purpose of macro trading, relevant systemic risk indicators should feature intelligent debt-to-GDP ratios and trackers of collateral values.

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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.

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