The consequences of increased financial collateralization

November 18, 2017

There has been a strong upward trend in collateralization since the great financial crisis. Suitable collateral, such as government bonds, is essential for financial transactions, particularly repurchase agreements and derivative contracts. Increased collateralization poses new risks. Collateral prices and haircuts are pro-cyclical, which means that collateralized transactions flourish when assets values rise and slump when asset values decline. This creates links between leverage, asset prices, hedging costs and liquidity across many markets. Trends are mutually reinforcing and can escalate into fire sales and market paralysis. Central clearing cannot eliminate this escalation risk. The collateral policies of central banks have become more important.

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How bank regulatory reform has changed macro trading

October 21, 2017

The great regulatory reform in global banking has altered the backdrop for macro trading. First, greater complexity and policymaker discretion means that investment managers must pay more attention to regulatory policies, not unlike the way they follow monetary policies. Second, changes in capital standards interfere with the effects of monetary conditions and probably held back their full impact on credit conditions in past years. Third, elevated capital ratios and loss-absorption capacity will plausibly contain classical banking crises in the future and, by themselves, reduce the depth of recessions. Fourth, regulatory tightening seems to have reduced market liquidity and may increase the depth of market price downturns.

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Critical transitions in financial markets

September 30, 2017

Critical transitions in financial markets are shifts in prices and operational structure to a new equilibrium after reaching a tipping point. “Complexity theory” helps analysing and predicting such transitions in large systems. Quantitative indicators of a market regime change can be a slowdown in corrections to small perturbations, increased autocorrelation of prices, increased variance and skewness of prices, and a “flickering” of markets between different states. A new research paper applies complexity theory to changes in euro area fixed income markets that arose from non-conventional policy. It finds that quantitative indicators heralded critical structural shifts in unsecured money markets and high-grade bond markets.

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China’s internal debt overload: a refresher

August 26, 2017

According to the latest IMF China report credit to non-financial institutions has soared to over 230% of GDP, an increase of 60%-points and a doubling in nominal terms from 2011 to 2016. Credit efficiency, i.e. the benefit of new lending in terms of economic output, has deteriorated markedly. Corporate lending has soared with an outsized allocation to state-owned enterprises, particularly to “zombie” and overcapacity firms. The credit boom has been supported by an abnormally high national savings rate of over 45% of GDP, which is likely to decline going forward. Historically, almost all credit booms that were similar to China’s in size and speed ended in a major downturn or credit crisis.

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Building international financial conditions indices

April 29, 2017

IMF staff has developed global financial conditions indices for 43 global economies. Conceptually, these indices extract the communal component of range of indicators for local financing conditions, independent of economic conditions. The idea looks like a good basic principle for building FCIs for macro trading strategies. The research on these indices suggests that [1] financial conditions are a warning sign for recessions, and [2] global financial shocks have a powerful impact on local conditions, particularly in the short run and in emerging economies.

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Trend following and the headwinds of rising yields

April 2, 2017

The decline in bond yields over the past decades has supported profitability and diversification value of trend followers. Returns have been boosted by a persistent secular downward drift in interest rates and persistent positive carry. Diversification value owed to negative correlation of long duration positions with equity and credit returns, reflecting the dominance of deflationary over inflationary shocks. However, in a rising yield environment carry would work against the trend follower, while diversification value is dubious. A simple simulation that reverses the yield dynamics over the past 15 years suggests that a generic trend following strategy could perform poorly in a rising yield environment.

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Inflation: risk without premium

December 31, 2016

Historically, securities that lose value as inflation increases have paid a sizable risk premium. However, there is evidence that inflation risk premia have vanished or become negative in recent years. Macroeconomic theory suggests that this is related to monetary policy constraints at the zero lower bound: demand shocks are harder to contain and cause positive correlation between inflation and growth. Assets whose returns go down with higher inflation become valuable proxy-hedges. As a consequence, inflation breakevens underestimate inflation. Bond yields would rise disproportionately once policy rates move away from the zero lower bound.

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The macroeconomic impact of Basel III

November 19, 2016

The regulatory capital reform for banks increases capital costs and credit spreads charged on clients. However, it also clearly reduces the tail risk of future banking system crises. And these crises have historically subtracted on average about 100% of an annual GDP overtime. Hence, a BIS paper finds that long-term growth benefits outweigh costs. One implication may be that once capital adjustment is complete and higher capital ratios are firmly established regulation headwinds for equity and credit markets turn into tailwinds.

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The global debt overhang

October 15, 2016

A new IMF report illustrates that a large share of both advanced and emerging economies struggle with private debt overhangs. Excessive debt is a drag on growth and a risk for financial stability. Low nominal growth has hampered deleveraging and aggravates these dangers. Moreover, high public sector debt has reduced governments’ capacity to support private balance sheets and stabilize economic growth in future crises. Therefore, the lingering debt overhang provides a strong incentive for fiscal and monetary policies to work towards higher nominal GDP growth now.

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Japan’s yield curve control: the basics

October 8, 2016

The Bank of Japan has once again broken new grounds in monetary policy, now targeting not just the short-term policy rate but – within limits – the 10-year JGB yield. In practice the Bank will secure a positive yield curve against the backdrop of negative short-term rates and negative expected long-term real rates. This is meant to mitigate the debilitating effect of yield compression on the financial system and, probably, to contain the risk of bond yield tantrums in case domestic spending and inflation do pick up. As a side effect, the policy would subsidize long duration carry trades and long-long equity-duration risk parity positions.

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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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