How central banks can take nominal rates deeply negative

May 18, 2019

The popular view that nominal interest rates have a natural zero lower bound has become obsolete in modern financial systems. It may be more appropriate to consider this boundary a convenient policy choice that can be revised. Technically, the zero lower bound arises from potential arbitrage at negative nominal rates, in the form of cash withdrawal, storage and redeposit. However, the central bank can break this arbitrage by using its power at the cash window, i.e. by altering the conditions at which commercial banks can withdraw and redeposit paper money. There are two viable options for doing so. The so-called ‘clean approach’ creates a crawling exchange rate between paper money and electronic money, effectively devaluing the former relative to the latter at a predictable continuous rate. The so-called ‘rental fee approach’ charges commercial banks for using paper money and is equivalent to imposing negative rates on cash held by the private sector.

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Bayesian Risk Forecasting

May 4, 2019

Portfolio risk forecasting is subject to great parameter uncertainty, particularly for longer forward horizons. This simply reflects that large drawdowns are observed only rarely, making it hard to estimate their ‘structural’ properties. Bayesian forecasting addresses parameter uncertainty directly when estimating risk metrics, such as Value-at-Risk or Expected Shortfall, which depend on highly uncertain tail parameters. Also, the Bayesian risk forecasting method can use ‘importance sampling’ for generating simulations that oversample the high-loss scenarios, increasing computational efficiency. Academic work claims that Bayesian methods also produce more accurate risk forecasts for short- and long-term horizons.

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The duration extraction effect

April 13, 2019

Under non-conventional monetary policy central banks influence financial markets through the “portfolio rebalancing channel”. The purchase of assets changes the structure of prices. A particularly powerful portfolio rebalancing effect arises from duration extraction, i.e. the combined size expansion and duration extension of the assets that have been absorbed onto the central bank’s balance sheet. Duration extraction has a significant and persistent impact on the yield curve and the exchange rate. Importantly, the effect arises from hints or announcements of new parameters for the future stock of assets. Given the large size of central bank balance sheets, this explains why changes in expected asset purchases, re-investments or redemption plans have a profound impact on financial markets.

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Tiered reserve systems

April 6, 2019

Negative monetary policy rates can undermine financial transmission, because they encourage cash hoarding and reduce the profitability of traditional banking. This danger increases with depth and duration of negative interest rate policies. Therefore, some countries (Japan, Sweden, Switzerland, and Denmark) have introduced tiered reserve systems, effectively exempting a part of the banking system’s excess reserves from negative rates. Importantly, a tiered reserve system is now also considered by the European Central Bank for the second largest currency area in the world. Since tiered reserve systems are on the verge of “going mainstream” their impact on asset pricing formulas and quantitative trading strategies deserves careful consideration.

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Signaling systemic risk

March 23, 2019

Systemic financial crises arise when vulnerable financial systems meet adverse shocks. A systemic risk indicator tracks the vulnerability rather than the shocks (which are the subject of ‘stress indicators’). A systemic risk indicator is by nature slow-moving and should signal elevated probability of financial system crises long before they manifest. A recent ECB paper proposed a practical approach to building domestic systemic risk indicators across countries. For each relevant categories of financial vulnerability, one representative measure is chosen on the basis of its early warning qualities. The measures are then normalized and aggregated linearly. In the past, aggregate systemic risk indicators would have shown vulnerability years ahead of crises. They would also have indicated the depth of ensuing economic downturns.

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How to estimate risk in extreme market situations

March 16, 2019

Estimating portfolio risk in extreme situations means answering two questions: First, has the market entered an extreme state? Second, how are returns likely to be distributed in such an extreme state? There are three different types of models to address these questions statistically. Conventional “extreme value theory” really only answers the second question, by fitting an appropriate limiting distribution over observations that exceed a fixed threshold. “Extreme value mixture models” simultaneously estimate the threshold for extreme distributions and the extreme distribution itself. This method seems appropriate if uncertainty over threshold values is high. Finally, “changepoint extreme value mixture models” even go a step further and estimate the timing and nature of changes in extreme distributions. The assumption of changing extreme distributions across episodes seems realistic but should make it harder to apply the method out-of-sample.

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Understanding China’s “financial policy”

February 23, 2019

In most developed countries macroeconomic management is the domain of separate fiscal and monetary policies. In China, the focus is on “financial policy”, a combination of credit, monetary and regulatory policies with powerful direct effects on growth and stability. This “financial policy” has critically shaped the structural development of the economy, fostering particularly state-owned enterprises, heavy industry, and real estate. It has left the economy with a difficult legacy of inefficient credit allocation, bloated shadow banking, and financial systemic risk in the real estate sector. Reforms since 2016 seek to normalize China’s macroeconomic policies but have created severe tensions between the objectives of deleveraging and sufficient growth.

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ECB policy framework in six basic points

January 26, 2019

The European Central Bank is one of the most powerful institutions in the world and is running a particularly complex policy framework. For macro trading and financial modelling, the following points are critical: [1] The primary policy objective is medium-term inflation, with a horizon of two years or more and symmetric aversion to deviations from a mean of just below 2%. [2] In practice, policy rate setting has followed a simple dynamic Taylor-type rule. [3] The operational framework is very broad, with a wide range of counterparties and instruments. [4] The ECB has extensive experience with four types of non-conventional policies (long-term lending operations, asset purchases, negative interest rates, and forward guidance) that jointly exercise powerful influence on financial conditions. [5] The effectiveness ECB policy depends critically on coordinated national fiscal and regulatory policies. [6] Special mechanisms have been put in place to contain redenomination risk, i.e. fears that assets might be redenominated into legacy currencies.

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How systemic financial risk is measured

November 10, 2018

Public institutions have developed a wide range of methods to track systemic financial risk. What most of them have in common is reliance on financial market data. This implies that systemic risk indicators typically only show what the market has already priced, in form of correlation, volatility or value. They cannot anticipate market crises. Their main use is to predict when and how market turmoil begins to sap the functioning of the financial system. Some methods may be useful for macro trading. For example, Conditional Value-at-Risk can identify sources of systemic risk, such as specific institutions or market segments. Principal Components Analysis can indicate changing concentration of risk across securities and markets.

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How convenience yields have compressed real interest rates

November 3, 2018

Real interest rates on ‘safe’ assets such as high-quality government bonds had been stationary around 2% for more than a century until the 1980s. Since then they have witnessed an unprecedented global decline, with most developed markets converging on the U.S. market trend. There is evidence that this trend decline and convergence of real rates has been due prominently to rising convenience yields of safe assets, i.e. greater willingness to pay up for  safety and liquidity. This finding resonates with the historic surge in official foreign exchange reserves, the rising demand for high-quality liquid assets for securitized transactions and the preferential treatment of government bonds in capital and liquidity regulation (view previous post here).

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