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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China’s augmented fiscal challenge

June 15, 2013

A very short note by the IMF in the run-up of China’s latest Article IV consultations suggests that the country’s fiscal position is much weaker than official statistics suggest. The augmented fiscal deficit of the country, including local government off-budget funding, is estimated to have climbed to around 10% of GDP.

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The “reach for yield” bias of institutional investors

June 5, 2013

‘Reach for yield’ describes regulated investors’ preference for high-risk assets within the confines of a rule-based risk metric (such as credit ratings or VaR). Bo Becker and Victoria Ivashina provide evidence that U.S. insurance companies act on this principle and show that ”conditional on ratings, insurance portfolios are systematically biased toward higher yield bonds”. ‘Reach for yield’ would be a form of regulatory arbitrage, a source of inefficiency, and a reward for “unaccounted risk” of securities and issuers.

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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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Quantitative easing and “VaR shocks”

May 19, 2013

Securities held by VaR (Value-at-Risk)-sensitive institutional investors, such as banks, are prone to escalatory selling pressure after an initial shock, in particular if they make up a substantial portion of the portfolio. Nikolaos Panigirtzoglou underscores that the Japanese government bond market has already demonstrated its proclivity to such ‘VaR shocks’. Also on a global scale government bond yields may overtime become more vulnerable, as one of the unintended consequences of quantitative easing.

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The effectiveness of non-conventional monetary policy

May 18, 2013

The latest IMF publications on non-conventional monetary policies affirm their effectiveness. This seems to hold true for all major forms, i.e. government bond purchases, forward guidance, and private asset purchases. However, bond purchases are likely to yield diminishing effects going forward. Their initial stimulus seems to owe much to the signalling of commitment and the repair of broken markets. Also, the economic impact seems to have a time limit. Meanwhile additional credible yield compression becomes ever more difficult as the zero boundary is drawing closer and central banks would struggle to extend commitments to ever longer durations.

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Historical precursor of Abenomics

May 13, 2013

Warwick professor Nicolas Crafts notes that the UK’s exit from recession and deflation in 1930s has similarities to Japan’s current expansionary policy. At the time the UK managed recovery and reflation through very low rates and initial currency devaluation. Crafts argues that such strategies may require abandoning inflation-targeting independent central banks.

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China’s highly leveraged state-owned corporates

May 3, 2013

Morgan Stanley’s Viktor Hjort, Nishant Sood, and Gaurav Singhal show that financial leverage of China’s corporates has reached record highs, particularly for state-owned enterprises (SOEs). Increased debt financing reflects easy credit conditions and has partly served to cover funding gaps. In case of an economic downturn, consequences for credit quality would probably be more severe now than back in 2009.

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Nomura research on rising China crisis risk

April 23, 2013

According to Nomura’s Zhiwei Zhang and Wendy Chen, “China is displaying the same three symptoms that Japan, the US and parts of Europe all showed before suffering financial crises: a rapid build-up of leverage, elevated property prices and a decline in potential growth…the most vulnerable areas are local government financing vehicles, property developers, trust companies and credit guarantee companies.”

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Useful summary of fiscal developments from the IMF

April 20, 2013

The IMF Fiscal Monitor provides the usual insightful global summary of public finance trends. It reveals significant progress in the reduction of structural deficits in the developed world, at the price of drastic fiscal tightening that will aggravate further this year. However, public debt ratios have yet to peak and their current levels bode ill for future growth and government shock-absorption capabilities. A major implicit concern is Japan, where the structural deficit has not been reduced and both net and gross debt have been soaring.

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