Fire sale risk through the U.S. repo market

July 18, 2013

The Federal Reserve Bank of New York continues to highlight the latent risk of fire sales in the tri-party repo market. The danger arises from an incentive to liquidate collateral in case the solvency of a dealer is in doubt. The risk is enhanced by the vulnerability of the main cash lenders intri-party repos, money market mutual funds and security lenders, to liquidity pressure. Policy tools to contain such an event are limited.

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Why CDS spreads can decouple from fundamentals

July 16, 2013

A Bundesbank working paper provides evidence that Credit Default Swap (CDS) spreads change significantly in accordance with (i) the direction of order flows, (ii) the size of transactions, and (iii) the type of counterparty. Apparent causes are asymmetric information, inventory risk and market power. The implication is powerful. Since transactions do not require commensurate changes in fundamentals and since CDS spreads are themselves used for risk management, institutional order flows can easily establish escalatory dynamics.

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The full scope of U.S. federal government liabilities

July 12, 2013

James Hamilton from the University of California has published some scary numbers on growth and size of U.S. federal government liabilities that are not included in the official debt statistics. Their main constitutents are underfunded Social Security and Medicare liabilities, loan guaranties, and the federal deposit insurance. According to the Hamilton’s research ‘the total dollar value of notional off-balance-sheet commitments came to USD70 trillion as of 2012, or 6 times the size of the reported on-balance-sheet debt’.

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Japanese banks’ vulnerability to rising bond yields

July 10, 2013

Standard & Poor’s research suggests that Japanese banks’ government bond holdings and interest rate risks of have almost doubled over the past 10 years. Against the backdrop of more aggressive reflation policies (view here) this translates into a systemic risk. An increase in long-term yields by 200bps compared to 2012 could already impair the banking system. An increase by 300bps or more could spell broadly based challenges for capital adequacy. A concurrent drop in equity would increase the pressure.

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Asia’s systemic credit risks

July 8, 2013

A new Standard Chartered Research Report investigates pockets of potential credit risk in Asia, by using a new comprehensive set of metrics. China’s overleveraged corporates are at the forefront of concerns, as mentioned in other posts (view here). Japan’s massive 400% debt-to-GDP ratio is a potentially large risk if real interest rates in the country ever increase. India is burdened with a high government debt ratio and an apparently deteriorating profile of corporate debt.

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New rules for euro area bank bailouts

July 6, 2013

Jacob Funk Kirkegaard, senior fellow of the Peterson Institute, has published an excellent summary on the euro area’s political deal for bank recapitalisation and resolution, targeted at breaking “doom loops”, i.e. escalating negative feedback of banking and sovereign solvency troubles. The key parts, from a market perspective, are (i) the possibility of direct recapitalisation of banks through the European Stability Mechanism (even retroactively) and (ii) stricter bail-in rules for private bond and equity owners.

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U.S. Fed “tapering”: The basics in the FOMC’s own words

July 1, 2013

Envisaged Fed tapering is simply predicated on five principles: (a) balance sheet expansion will slow and ultimately cease if unemployment declines on a sustained basis to around 7%, (b) the pace of asset purchases remains data dependent, hinging on sustained labor market improvement and financial conditions, (c) tapering is not meant to tighten monetary conditions, (d) tapering does not per se lead to subsequent unwinding of Treasury holdings and may never result in MBS sales, and (e) tapering does not per se bring forward Fed fund rate hikes, which are subject to higher thresholds.

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What we can learn from Asia’s “tapering”

June 30, 2013

J.P. Morgan’s David Fernandez points out that central bank “tapering” (moderation of balance sheet expansion and related monetary accommodation, currently envisaged by the U.S. Federal reserve) has a precedent of sorts. Emerging Asia had ramped up central bank assets for a decade after the 1997-98 crisis, mainly though FX interventions to bolster financial stability and competitiveness. Asia has been unwinding part of that expansion, passively and in line with smaller external surpluses, since 2008. The initial balance sheet expansion did not undermine credibility and price stability. And the subsequent reduction may be interpreted as a positive normalization, reducing the risk of financial bubbles.

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Monetary financing does not preclude sovereign default

June 27, 2013

Most investors take for granted that a government with access to monetary financing cannot be driven to default. However, a new paper by Corsetti and Dedola challenges this belief. Monetary financing incurs costs and, hence, preference for default and self-fulfilling confidence crises are possible. Necessary conditions to rule out self-fulfilling crises include credible caps on government borrowing rates, the ability of the central bank to issue default-free, interest-bearing, and non-inflationary “reserves” (rather than cash), and full coverage of central bank losses by the state budget.

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Self-fulfilling tightening and recessions in a low interest rate world

June 23, 2013

A new Bank of England paper points to a dangerous pitfall for monetary policy in a low rates environment. “Speed-limit rules” stipulate that central banks adjust policies in accordance with the change in the economy (e.g. growth, the unemployment rate, or inflation), not its level, in order to avoid policy errors and anchor expectations. At the zero bound these rules can lead to self-fulfilling recessions, as a downshift in (growth and inflation) expectations triggers less hope for policy easing than fears for subsequent tightening (when the initial downshift is being reversed). In my view this dovetails recurrent fears of convexity or jump risk in low-yield bond markets, and may help explaining why global central banks at the zero bound have so far struggled to produce sustained recoveries.

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