Category: Interesting External Papers

Interesting External Papers

BoC on How Trading Works

The Bank of Canada has released a working paper by George J. Jiang and Ingrid Lo titled Private Information Flow and Price Discovery in the U.S. Treasury Market:

Existing studies show that U.S. Treasury bond price changes are mainly driven by public information shocks, as manifested in macroeconomic news announcements and events. The literature also shows that heterogeneous private information contributes significantly to price discovery for U.S. Treasury securities. In this paper, we use high frequency transaction data for 2-, 5-, and 10-year Treasury notes and employ a Markov switching model to identify intraday private information flow in the U.S. Treasury market. We show that the probability of private information flow (PPIF) identified in our model effectively captures permanent price effects in U.S. Treasury securities. In addition, our results show that public information shocks and heterogeneous private information are the main factors of bond price discovery on announcement days, whereas private information and liquidity shocks play more important roles in bond price variation on non-announcement days. Most interestingly, our results show that the role of heterogeneous private information is more prominent when public information shocks are either high or low. Furthermore, we show that heterogeneous private information flow is followed by low trading volume, low total market depth and hidden depth. The pattern is more pronounced on non-announcement days.

I have often made the point that the reverence shown by the media for traders is misplaced. They don’t make huge profits by keen analysis; they only need to be smart enough to sell at higher prices than they buy. The paper describes how this works:

One challenge of our study is that compared to public information flow in the Treasury market, which generally coincides with news announcements, private information flow is not directly observed. In this paper, we use the impact of order flow on bond prices to infer private information flow. For example, Brandt and Kajeck (2004) argue that order flow impact effectively captures heterogeneous information flow in the U.S. Treasury market. Empirically, Green (2004), Pasquariello and Vega (2007) use order flow impact to proxy for the level of information asymmetry on announcement versus nonannouncement days in the Treasury market. Loke and Onayev (2007) also find state-varying level of order flow impact in the S&P futures market. Using information from order flow impact, we specify a Markov switching model to identify private information flow. Using high frequency transaction data for the 2-, 5-, and 10-year Treasury notes, we obtain 5-minute estimates of the probability of private information flow (PPIF hereafter). In this aspect, our model can be viewed as an extension of the existing PIN model by Easley et al. (2002) and Li et al. (2009).

The data used in our study is obtained from the BrokerTec electronic limit order book platform on which secondary interdealer trading occurs. It contains not only tick-by-tick information on transaction and market quotes but also information of the entire limit order book for the on-the-run 2-year, 5-year, and 10-year notes. This allows us to examine the effect of heterogeneous private information in high frequency. The detailed information on the limit order book also allows us to examine how liquidity dynamics interact with private information. A novel aspect of our paper is that we examine how liquidity reacts to information uncertainty. Given that the timing and the context of information arrival is unknown on non-announcement days, we look at how trading activities and placement of limit orders differs from that on announcement days. Data on announcements comes from Bloomberg and includes date, time and values for expected and actual announcements. Since surveys of market participants provide ex ante expectations of major economic announcements, measures of announcement surprises or unexpected information shocks can be constructed.

Our results show that PPIF is higher for longer maturity bonds, and higher on announcement days than on non-announcement days. The finding is consistent with Brandt and Kavajecz (2004) that price discovery manifests in less liquid markets. In addition, on announcement days, PPIF coincides with public information shocks as measured by announcement times.This is consistent with Green(2004) finding that the role of private information is hihger [sic] at and after announcements.

If you’re a trader and do this, you’re smart. But if you create a computerized expert system to do this, you’re an evil High-Frequency Trader.

Interesting External Papers

High Frequency Traders and Asset Prices

Jaksa Cvitanic, Andrei A. Kirilenko have published a paper titled High Frequency Traders and Asset Prices:

Do high frequency traders affect transaction prices? In this paper we derive distributions of transaction prices in limit order markets populated by low frequency traders (humans) before and after the entrance of a high frequency trader (machine). We find that the presence of a machine is likely to change the average transaction price, even in the absence of new information. We also find that in a market with a high frequency trader, the distribution of transaction prices has more mass around the center and thinner far tails. With a machine, mean intertrade duration decreases in proportion to the increase in the ratio of the human order arrival rates with and without the presence of the machine; trading volume goes up by the same rate. We show that the machine makes positive expected profits by “sniping” out human orders somewhat away from the front of the book. This explains the shape of the transaction price density. In fact, we show that in a special case, the faster humans submit and vary their orders, the more profits the machine makes.

They specify:

Machines are assumed to be strategic uninformed liquidity providers. They have only one advantage over the humans – the speed with which they can submit or cancel their orders. Because of this advantage, machines dominate the trading within each period by undercutting slow humans at the front of the book. This is only one of the strategies used by actual high-frequency traders in real markets, and the only one we focus on.[footnote] In the language of the industry, machines aim to “pick-off” or “snipe out” incoming human orders.

Footnote: Other known high frequency trading strategies include (i) the collection of rebates offered by exchanges for liquidity provision, (ii) cross-market arbitrage, and (iii) “spoofing”- triggering other traders to act.

The guts of the paper is:

We find that the presence of a machine is likely to change the average transaction price, even in the absence of new information. We also find that in the presence of a machine, the shape of the transaction price density remains the same in the middle, between the bid and the ask of the machine, the far tails of the density get thinner, while the parts of the tails closer to the bid and the ask of the machine get fatter. In the presence of the machine, mean intertrade duration decreases in proportion to the increase in the ratio of the human order arrival rates with and without the presence of the machine. Trading volume goes up by the same rate. In other words, if the humans submit orders ten times faster when the machine is present, intertrade duration falls and trading volume increases by a factor of ten.

Second, we compute the optimal bid and ask prices for the machine that optimizes expected profits subject to an inventory constraint. The inventory constraint prevents the machine from carrying a significant open position to the next intra-human-trade period. The optimal bid and the ask for the machine are close to being symmetric around the mean value of the human orders, with the distance from the middle value being determined by the inventory constraint – the less concerned the machine is about the size of the remaining inventory, the closer its bid and the ask prices are to each other. The expected profit of an optimizing machine is increasing in both the variance and the arrival frequency of human orders.

Our two findings are interrelated; one the one hand, an optimizing machine is able to make positive expected profits by “sniping” out human orders somewhat away from the front of the book. On the other hand, execution of the “sniping” order submission strategy results in a transaction price density with bulges near the front and thinner outer tails. In fact, in a special case, the faster humans submit and vary their orders, the more profits the machine makes.


Click for big

The conclusion of interest is:

We also find that a machine that optimizes expected profits subject to an inventory constraint submits orders that are essentially symmetric around the mean value of the human orders. The distance between the machine’s bid and ask prices increases with its concern about the size of the remaining inventory. The expected profit of an optimizing machine increases in both the variance and the arrival frequency of human orders.

Briefly mentioned on October 18 was High Frequency Trading and its Impact on Market Quality:

In this paper I examine the impact of high frequency trading (HFT) on the U.S. equities market. I analyze a unique dataset to study the strategies utilized by high frequency traders (HFTs), their profitability, and their relationship with characteristics of the overall market, including liquidity, price discovery, and volatility. The 26 HFT firms in the dataset participate in 68.5% of the dollar-volume traded. I find the following key results: (1) HFTs tend to follow a price reversal strategy driven by order imbalances, (2) HFTs earn gross trading profits of approximately $2.8 billion annually, (3) HFTs do not seem to systematically engage in a non-HFTr anticipatory trading strategy, (4) HFTs’ strategies are more correlated with each other than are non-HFTs’, (5) HFTs’ trading levels change only moderately as volatility increases, (6) HFTs add substantially to the price discovery process, (7) HFTs provide the best bid and offer quotes for a significant portion of the trading day and do so strategically so as to avoid informed traders, but provide only one-fourth as much book depth as non-HFTs, and (8) HFTs may dampen intraday volatility. These findings suggest that HFTs’ activities are not detrimental to non-HFTs and that HFT tends to improve market quality.

He provides a good discussion of pinging:

Pinging is defined by the SEC as, “an immediate-or-cancel order that can be used to search for and access all types of undisplayed liquidity, including dark pools and undisplayed order types at exchanges and ECNs. The trading center that receives an immediate-or-cancel order will execute the order immediately if it has available liquidity at or better than the limit price of the order and otherwise will immediately respond to the order with a cancelation” (SEC, January 14, 2010). The SEC goes on to clarify, “[T]here is an important distinction between using tools such as pinging orders as part of a normal search for liquidity with which to trade and using such tools to detect and trade in front of large trading interest as part of an ‘order anticipation’ trading strategy” (SEC, January 14, 2010).

Of interest is the section titled “10-Second High Frequency Trading Determinants”:

This section examines the factors that influence HFTs’ buy and sell decisions. I begin by testing a variety of potentially important variables in an ordered logistic regression analysis. The results show the importance of past returns. I carry out a logistic regression analysis distinguishing the dependent variables based on whether the HFTr is buying or selling and whether the HFTr is providing liquidity or taking liquidity. Finally, I include order imbalance in the logit analysis and find that the interaction between past order imbalance and past returns drives HFTr activity and is consistent with HFTs engaging in a short term price reversal strategy.

Also of interest is the section titled “Testing Whether High Frequency Traders Systematically Engage in Anticipatory Trading”:

In this section I test whether HFTs systematically anticipate and trade in front of non-HFTs (“anticipatory trading”) (SEC, January 14, 2010). It may be that HFTs predict and buy (sell) a stock just prior to when a non-HFTr buys (sells) the stock. If this is the case, HFTs are profiting at the expense of non-HFTs.[footnote]

Footnote: Anticipatory trading is not itself an illegal activity. It is illegal when a firm has a fiduciary obligation to its client and uses the client’s information to front run its orders. In my analysis, as HFTs are propriety trading firms, they do not have clients and so the anticipatory trading they may be conducting would likely not be illegal. Where HFT and anticipatory trading may be problematic is if market manipulation is occurring that is used to detect orders. It may be the case that “detecting” orders would fall in to the same category of behavior as that resulted in a $2.3 million fine to Trillium Brokerage Services for “layering”.

Trillium was fined for the following layering strategy: Suppose Trillium wanted to buy stock X at $20.10 but the current offer price was $20.13, Trillium would put in a hidden buy order at $20.10 and then place several limit orders to sell where the limit orders were sufficiently below the bid price to be executed. Market participants would see this new influx of sell orders, update their priors, and lower their bid and offer prices. Once the offer price went to $20.10, Trillium’s hidden order would execute and Trillium would then withdraw its sell limit orders. FINRA found this violated NASD Rules 2110, 2120, 3310, and IM-3310 (now FINRA 2010, FINRA 2020, FINRA 5210, and also part of FINRA 5210).

I don’t have any problems with what Trillium did – it’s just another example of random illegality. By me, that just shows that most traders are little girls with no conception whatsoever of fundamental value and FINRA panders to them. FINRA’s press release states … :

In concluding this settlement, Trillium and the individual respondents neither admitted nor denied the charges, but consented to the entry of FINRA’s findings.

… from which I conclude that FINRA doesn’t think it was a crime either and the whole thing was simply a case of regulatory extortion.

Of great interest is the author’s estimate of the effect of HFT on market impact:

Figure 4: Time Series of High Frequency Traders’ and Non High Frequency Traders’ Book Depth. This Figure analyzes the depth of the order book and how much depth different types of traders provide by analyzing the price impact of a 1000 share trade hitting the order book with and without different types of traders. There are three graphs. The first, Price Impact of a 1000 Share Trade, examines the total price impact a 1000 share trade would have with all available liquidity accessible. The second graph, Additional Price Impact without HFTs on the Book, depicts the additional price impact that would occur from removing HFTs’ limit orders The third graph, Additional Price Impact without non-HFTs on the Book, graphs the additional price impact from removing non-HFTs’ limit orders. The daily dollar price impact value is calculated giving equal weight to each stock. The order book data is available during 10 5-day windows. The X-axis identifies the first day in the 5-day window. That is, The observation 01-07-08 is followed by observations on January 8th, 9th, 10th, and 11th of 2008. The next observation is for April 7, 2008 and is followed by the next four consecutive trading days. To separate the 5-day windows I enter a zero-impact trade, creating the evenly spaced troughs.


Click for big

Also of interest was the effect of the short-selling ban on market participation by HFT:

Figure A-1: High Frequency Trading’s Fraction of the Market around the Short-Sale Ban. The figure shows how HFTs’ fraction of dollar-volume trading varied surrounding the September 19, 2008 SEC imposed short-sale ban on many financial stocks. In the HFT dataset, 13 stocks are in the ban. The two graphs plot HFTs’ fraction of dollar-volume traded for the banned stocks and for the unaffected stocks. The first graph reports the fraction of dollar-volume where HFTs supplied liquidity. The second reports the fraction where HFTs demanded liquidity. I normalize the banned stocks’ percent of the market in both graphs so that the affected and unaffected stocks have the same percent of the market on September 2, 2008. The two vertical lines represent the first and last day of the short-sale ban.


Click for Big
Interesting External Papers

Inflation Risk Premium: Adrian & Wu

In a working paper published by the Federal Reserve Bank of New York, authored by Tobias Adrian & Hao Wu and titled The Term Structure of Inflation Expectations:

We present estimates of the term structure of inflation expectations, derived from an affine model of real and nominal yield curves. The model features stochastic covariation of inflation with the real pricing kernel, enabling us to extract a time-varying inflation risk premium. We fit the model not only to yields, but also to the yields’ variance-covariance matrix, thus increasing identification power. We find that model-implied inflation expectations can differ substantially from break-even inflation rates when market volatility is high. Our model’s ability to be updated weekly makes it suitable for real-time monetary policy analysis.

They point out:

However, breakeven inflation rates of zero-coupon off-the-run curves (i.e., implied inflation) still are not pure measures of inflation expectations. This is because the absence of arbitrage implies that the difference between zero-coupon nominal and real yields can be decomposed into three components:

Breakeven Inflation = Expected Inflation + Inflation Risk Premium + Convexity

The literature commonly adjust for the convexity effect (see Elsasser and Sack, 2004). However, the adjustment of breakeven inflation for the inflation risk premium requires the estimation of a term structure model.

The paper by Brian P. Sack and Robert Elsasser is titled Treasury Inflation-Indexed Debt: A Review of the U.S. Experience. The convexity complication is explained as:

One complication with interpreting inflation compensation involves the adjustment for convexity. For a given level of the yield on a nominal security, uncertainty about future inflation increases the expected return on that security. This is a mechanical relationship that arises from the convexity of real returns in inflation—specifically, because higher inflation erodes the real return on the security at a slower rate than lower inflation boosts it (see the appendix). This point was originally made by Fischer (1975); a more recent description of the relationship between inflation compensation and future inflation can be found in McCulloch and Kochin (1998).

Although convexity tends to pull down inflation compensation relative to expected inflation, there may be an inflation risk premium that works in the opposite direction.

The methodology of Adrian & Wu is:

In this paper, we develop an affine term structure model that captures the dynamics of real and nominal yields curves, as well as the evolution of their variance-covariance matrix. This is important, as the inflation risk premium is proportional to the conditional covariance of the real pricing kernel and inflation. In order to increase the power for identifying the inflation risk premium, we match both the term structure of the yield curves, and the term structure of variances and covariances.

We find a relatively small and stable inflation risk premium. The order of magnitude of the inflation risk premium is comparable to other recent estimates in studies that use inflation protected bonds over similar sample periods, but it is smaller and less variable than estimates that use nominal bonds and inflation over longer time periods (see Buraschi and Jiltsov, 2005, and Ang, Bekaert, and Wei, 2006).


Click for Big
Interesting External Papers

Inflation Risk Premium: Christensen, Lopez & Rudebusch

The Federal Reserve Bank of San Francisco has published a working paper by Jens H. E. Christensen, Jose A. Lopez and Glenn D. Rudebusch titled Inflation Expectations and Risk Premiums in an Arbitrage-Free Model of Nominal and Real Bond Yields:

Differences between yields on comparable-maturity U.S. Treasury nominal and real debt, the so-called breakeven inflation (BEI) rates, are widely used indicators of inflation expectations. However, better measures of inflation expectations could be obtained by subtracting inflation risk premiums from the BEI rates. We provide such decompositions using an estimated affine arbitrage-free model of the term structure that captures the pricing of both nominal and real Treasury securities. Our empirical results suggest that long-term inflation expectations have been well anchored over the past few years, and inflation risk premiums, although volatile, have been close to zero on average.

This contradicts the results of Haubrich, et al, from the FRB-Cleveland, (paper reviewed on PrefBlog) who claimed:

The inflation risk premium on a ten-year bond varied between 38 and 60 basis points during our [1982-2008] sample period.

while the FRBNY paper by Adrian & Wu (discussed below) claimed a 0-40bp Inflation Risk Premium for 5-10 year time horizons.

The Christensen group first did a Principal Component Analysis of Treasury yields:

Researchers have typically found that three factors, often referred to as level, slope, and curvature, are sufficient to account for the time variation in the cross section of nominal Treasury yields (e.g., Litterman and Scheinkman, 1991). This characterization is supported by a principal component analysis of our weekly data set, which consists of Friday observations from January 6, 1995, to March 28, 2008, for eight maturities: three months, six months, one year, two years, three years, five years, seven years, and ten years. Indeed, as shown in Table 1, 99.9 percent of the total variation in this set of yields is accounted for by the first three principal components. Furthermore, the loadings across the eight maturities for the first component are quite uniform; thus, like a level factor, a shock to this component will change all yields by a similar amount. The second component has negative loadings for short maturities and positive loadings for long ones; thus, like a slope factor, a shock to this component will steepen or flatten the yield curve. Finally, the third component has U-shaped factor loadings as a function of maturity and is naturally interpreted as a curvature factor.

Only the first two principal components are required to explain real yields – best of all, the “slope” component is well-correlated with that of nominals:


Click for Big

After developing the model, they conclude:

Finally, for our preferred specification, we subtract each model-implied expected inflation rate from the comparable-maturity model-implied BEI rate and obtain the associated inflation risk premium (IRP). At both the five- and ten-year horizons, these premiums are fairly small, as shown in Figure 5.(17) Indeed, during our sample, these inflation premiums have varied in a range around zero of about ±50 basis points.(18)

Footnote 17: This result provides some support for the argument that the gain to the U.S. Treasury from issuing TIPS bonds instead of nominal bonds may be quite limited, as argued in Sack and Elsasser (2004).

Footnote 18: Again, in theory, the sign of the inflation risk premium depends on the covariance between the real stochastic discount factor and inflation, but there are real-world considerations as well. For example, a liquidity premium for holding TIPS instead of nominal Treasury bonds would show up as a negative inflation risk premium.


Click for Big

Finally, the authors conclude:

This paper estimates an arbitrage-free model with four latent factors that can capture the dynamics of both the nominal and real Treasury yield curves well and can decompose BEI rates into inflation expectations and inflation risk premiums. The model-implied measures of inflation expectations are correlated closely with survey measures, while the estimated inflation risk premiums fluctuate in fairly close range around zero. The empirical results suggest that long-term inflation expectations have been well-anchored in the period from year-end 2002 through the first quarter of 2008.

Interesting External Papers

Inflation Risk Premium: Hördahl & Tristani

In a working paper published by the Bank for International Settlements, authored by Peter Hördahl and Oreste Tristani, titled Inflation risk premia in the US and the euro area:

We use a joint model of macroeconomic and term structure dynamics to estimate inflation risk premia in the United States and the euro area. To sharpen our estimation, we include in the information set macro data and survey data on inflation and interest rate expectations at various future horizons, as well as term structure data from both nominal and index-linked bonds. Our results show that, in both currency areas, inflation risk premia are relatively small, positive, and increasing in maturity. The cyclical dynamics of long-term inflation risk premia are mostly associated with changes in output gaps, while their high-frequency fluctuations seem to be aligned with variations in inflation. However, the cyclicality of inflation premia differs between the US and the euro area. Long term inflation premia are countercyclical in the euro area, while they are procyclical in the US.

This model is much more macro-oriented than most:

In this paper we focus on modelling and estimating the first of these two components – i.e. the inflation risk premium – in order to obtain a “cleaner” measure of investors; inflation expectations embedded in bond prices. In doing so, we try to reduce the risk that liquidity factors might distort our estimates by carefully choosing when to introduce yields on index-linked bonds in the estimations. We also include survey information on expectations, which should aid us in pinning down the dynamics of key variables in the model. Moreover, in order to understand the macroeconomic determinants of inflation risk premia we employ a joint model of macroeconomic and term structure dynamics, such that prices of real and nominal bonds are determined by the macroeconomic framework and investors’ risk characteristics. More specifically, building on Ang and Piazzesi (2003), we adopt the framework developed in Hördahl, Tristani and Vestin (2006), in which bonds are priced based on the dynamics of the short rate obtained from the solution of a linear forward-looking macro model and using an essentially a¢ ne stochastic discount factor (see Duffie and Kan, 1996; Dai and Singleton, 2000; Duffee, 2002).

They find a rather peculiar difference in the responses of EUR denominated bonds vs Treasuries to output-gap shocks:

There is however one striking di¤erence in the conditional dynamics of risk premia in the two currency areas. While we find that inflation premia always respond positively to upward inflation shocks, the response to output gap shocks di¤er between the US and the euro area. A positive output shock results in a higher inflation premium in the US, while it lowers it in the euro area. The positive relationship for the US could reflect perceptions of a higher risk of inflation surprises on the upside as the output gap widens, while the euro area result is consistent with investors becoming more willing to take on risks – including inflation risks – during booms, while they may require larger premia during recessions.

The model’s detailed results are:

Looking at the results in more detail, Figure 9 shows that a one standard deviation upward shock to the output gap (about 0.4%) in the US pushes the 10-year break-even rate up by around 15 basis points on impact. About two thirds of this e¤ect is due to a rising inflation premium, while one third corresponds to an increase in expected inflation as a result of the expansionary shock. At the 2-year horizon, the effect on the break-even rate is even larger, at around 26 basis points on impact, but now the bulk of this response is due to rising inflation expectations (16 basis points), whereas the inflation premium accounts for the remaining 10 basis points. Hence, a shock to the output gap seems to result in a parallel shift in the inflation premium, while inflation expectations react much more strongly for short horizons than long, reflecting the short- to medium-term persistence of output gap shocks. In the euro area, a positive shock to the output gap also raises expected inflation – and more so at the 2-year horizon than the 10-year horizon – but the inflation premium response is uniformly negative (Fig. 11). Moreover, as the expected inflation response declines with the horizon, the break-even response goes from being positive at the 2-year horizon to being slightly negative at 10 years.

The authors conclude, in part:

Our results show that the inflation risk premium is relatively small, positive, and increasing with the maturity, in the United States as well as in the euro area. Our estimated inflation premia vary over time as a result of changes to the state variables in the model. Specifically, in both economies the output gap and inflation are the main drivers of inflation premia. The broad movements in long-term inflation risk premia largely match those of the output gap, while more high-frequency premia fluctuations seem to be aligned with changes in the level of inflation.


Click for big
Interesting External Papers

QE2 and Inflation

The Federal Reserve Board of St. Louis has published an article by Richard G. Anderson, Charles S. Gascon, and Yang Liu titled Doubling Your Monetary Base and Surviving: Some International Experience:

The authors examine the experience of selected central banks that have used large-scale balancesheet expansion, frequently referred to as “quantitative easing,” as a monetary policy instrument. The case studies focus on central banks responding to the recent financial crisis and Nordic central banks during the banking crises of the 1990s; others are provided for comparison purposes. The authors conclude that large-scale balance-sheet increases are a viable monetary policy tool provided the public believes the increase will be appropriately reversed.

The authors review current and past examples of central bank balance sheet expansion and conclude:

During the past two decades, large increases — and decreases — in central bank balance sheets have become a viable monetary policy tool. Historically, doubling or tripling a country’s monetary base was a recipe for certain higher inflation. Often such increases occurred only as part of a failed fiscal policy or, perhaps, as part of a policy to defend the exchange rate. Both economic models and central bank experience during the past two decades suggest that such changes are useful policy tools if the public understands the increase is temporary and if the central bank has some credibility with respect to desiring a low, stable rate of inflation. We find little increased inflation impact from such expansions.

For monetary policy, our study suggests several findings:

  • (i) A large increase in a nation’s balance sheet over a short time can be stimulative.
  • (ii) The reasons for the action should be communicated. Inflation expectations do not move if households and firms understand the reason(s) for policy actions so long as the central bank can credibly commit to unwinding the expansion when appropriate.
  • (iii) The type of assets purchased matters less than the balance-sheet expansion.
  • (iv) When the crisis has passed, the balance sheet should be unwound promptly.

Econbrowser’s James Hamilton has presented a review of QE2 and concludes:

I agree with John that the primary effects of QE2 come from restructuring the maturity of government debt, and that any effects one claims for such a move are necessarily modest. But unlike John, I believe those modest effects are potentially helpful.

Just to reiterate, my position is that when you combine the Fed’s actions with the Treasury’s, the net effect has been a lengthening rather than shortening of the maturity structure:

given the modest size, pace, and focus of QE2, and given the size and pace at which the Treasury has been issuing long-term debt, the announced QE2 would have been associated with a move in the maturity structure of the opposite direction from that analyzed in our original research. The effects of the combined actions by the Treasury and the Fed would be to increase rather than decrease long-term interest rates.

He has also noted the effects on commodity prices:

I feel that there is a pretty strong case for interpreting the recent surge in commodity prices as a monetary phenomenon. Now that we know there’s a response when the Fed pushes the QE pedal, the question is how far to go.

My view has been that the Fed needs to prevent a repeat of Japan’s deflationary experience of the 1990s, but that it also needs to watch commodity prices as an early indicator that it’s gone far enough in that objective. In terms of concrete advice, I would worry about the potential for the policy to do more harm than good if it results in the price of oil moving above $90 a barrel.

And we’re uncomfortably close to that point already.

Oil is now over USD 90/bbl.

Another effect I haven’t seen discussed much is a reversal of crowding-out:

Company bond sales in the U.S. reached a record this week and relative yields on investment- grade debt shrank to the narrowest since May as money managers boosted bets economic growth is gaining momentum.

Issuance soared to $48.5 billion, eclipsing the $46.9 billion raised in the week ended May 8, 2009, as General Electric Co.’s finance unit sold $6 billion of notes in the largest offering in 11 months, according to data compiled by Bloomberg. Investment-grade bond spreads narrowed to 162 basis points, or 1.62 percentage points, more than Treasuries, Bank of America Merrill Lynch index data show.

Appetite for corporate debt is growing after annual sales topped $1 trillion for the second consecutive year as the securities return more than Treasuries.

Foreign borrowers dominated U.S. sales this week, with companies from Sydney-based Macquarie Group Ltd. to the U.K.’s Barclays Plc accounting for 57 percent of the total, Bloomberg data show.

“The expectation coming into this year was that Yankee issuance would be heavy,” said Jim Probert, managing director and head of investment grade capital markets at Bank of America Merrill Lynch. “There’s enough maturing debt coming out of European financials in particular that they needed to be in the marketplace, and right now, U.S. dollars is a good alternative, in addition to euros.”

Meanwhile, Janet L. Yellen, the Fed’s Vice-Chair, has delivered a speech titled The Federal Reserve’s Asset Purchase Program:

As inflation has trended downward, measures of underlying inflation have fallen somewhat below the levels of about 2 percent or a bit less that most Committee participants judge to be consistent, over the longer run, with the FOMC’s dual mandate. In particular, a modest positive rate of inflation over time allows for a slightly higher average level of nominal interest rates, thereby creating more scope for the FOMC to respond to adverse shocks. A modest positive inflation rate also reduces the risk that such shocks could result in deflation, which can be associated with poor macroeconomic performance.

Figure 3 depicts the results of such a simulation exercise, as reported in a recent research paper by four Federal Reserve System economists. For illustrative purposes, the simulation imposes the assumption that the purchases of $600 billion in longer-term Treasury securities are completed within about a year, that the elevated level of securities holdings is then maintained for about two years, and that the asset position is then unwound linearly over the following five years.

This trajectory of securities holdings causes the 10-year Treasury yield to decline initially about 1/4 percentage point and then gradually return toward baseline over subsequent years. That path of longer-term Treasury yields leads to a significant pickup in real gross domestic product (GDP) growth relative to baseline and generates an increase in nonfarm payroll employment that amounts to roughly 700,000 jobs.

Inflation and bank reserves. A second reason that some observers worry that the Fed’s asset purchase programs could raise inflation is that these programs have increased the quantity of bank reserves far above pre-crisis levels. I strongly agree with one aspect of this argument–the notion that an accommodative monetary policy left in place too long can cause inflation to rise to undesirable levels. This notion would be true regardless of the level of bank reserves and pertains as well in situations in which monetary policy is unconstrained by the zero bound on interest rates. Indeed, it is one reason why the Committee stated that it will review its asset purchase program regularly in light of incoming information and adjust the program as needed to meet its objectives. We recognize that the FOMC must withdraw monetary stimulus once the recovery has taken hold and the economy is improving at a healthy pace. Importantly, the Committee remains unwaveringly committed to price stability and does not seek inflation above the level of 2 percent or a bit less than that, which most FOMC participants see as consistent with the Federal Reserve’s mandate.

The research paper referenced in conjunction with Figure 3 is Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events? by Hess Chung, Jean-Philippe Laforte, David Reifschneider and John C. Williams:

Before the recent recession, the consensus among researchers was that the zero lower bound (ZLB) probably would not pose a significant problem for monetary policy as long as a central bank aimed for an inflation rate of about 2 percent; some have even argued that an appreciably lower target inflation rate would pose no problems. This paper reexamines this consensus in the wake of the financial crisis, which has seen policy rates at their effective lower bound for more than two years in the United States and Japan and near zero in many other countries. We conduct our analysis using a set of structural and time series statistical models. We find that the decline in economic activity and interest rates in the United States has generally been well outside forecast confidence bands of many empirical macroeconomic models. In contrast, the decline in inflation has been less surprising. We identify a number of factors that help to account for the degree to which models were surprised by recent events. First, uncertainty about model parameters and latent variables, which were typically ignored in past research, significantly increases the probability of hitting the ZLB. Second, models that are based primarily on the Great Moderation period severely understate the incidence and severity of ZLB events. Third, the propagation mechanisms and shocks embedded in standard DSGE models appear to be insufficient to generate sustained periods of policy being stuck at the ZLB, such as we now observe. We conclude that past estimates of the incidence and effects of the ZLB were too low and suggest a need for a general reexamination of the empirical adequacy of standard models. In addition to this statistical analysis, we show that the ZLB probably had a first-order impact on macroeconomic outcomes in the United States. Finally, we analyze the use of asset purchases as an alternative monetary policy tool when short-term interest rates are constrained by the ZLB, and find that the Federal Reserve’s asset purchases have been effective at mitigating the economic costs of the ZLB. In particular, model simulations indicate that the past and projected expansion of the Federal Reserve’s securities holdings since late 2008 will lower the unemployment rate, relative to what it would have been absent the purchases, by 1½ percentage points by 2012. In addition, we find that the asset purchases have probably prevented the U.S. economy from falling into deflation.

Interesting External Papers

Adverse Selection, Liquidity and Market Breakdown

The Bank of Canada has released a working paper by Koralai Kirabaeva titled Adverse Selection, Liquidity, and Market Breakdown:

This paper studies the interaction between adverse selection, liquidity risk and beliefs about systemic risk in determining market liquidity, asset prices and welfare. Even a small amount of adverse selection in the asset market can lead to fire-sale pricing and possibly to a market breakdown if it is accompanied by a flight-to-liquidity, a misassessment of systemic risk, or uncertainty about asset values. The ability to trade based on private information improves welfare if adverse selection does not lead to a market breakdown. Informed trading allows financial institutions to reduce idiosyncratic risks, but it exacerbates their exposure to systemic risk. Further, I show that in a market equilibrium, financial institutions overinvest into risky illiquid assets (relative to the constrained efficient allocation), which creates systemic externalities. Also, I explore possible policy responses and discuss their effectiveness.

He makes the point (tangentially) that the Efficient Market Hypothesis is dependent, in part, on an assumption of infinite liquidity:

Market liquidity is characterized by the cost (in terms of the foregone payo¤) of selling a long-term asset before its maturity.1 Two factors contribute to illiquidity in the market:a shortage of safe assets and adverse selection (characterized by the fraction of low quality assets in the market). On one hand, market liquidity depends on the amount of the safe asset held by investors that is available to buy risky assets from liquidity traders. Following the Allen and Gale ([9], [11]) “cash-in-the-market” framework, the market price is determined by the lesser of the following two amounts: expected payo¤ and the amount of the safe asset available from buyers per unit of assets sold. Therefore, this “cash-in-the-market” pricing may lead to market prices below fundamentals if there is not enough cash (safe assets) to absorb asset trades. On the other hand, market liquidity depends on the quality of assets traded in the market. In particular, adverse selection can cause market illiquidity if assets sold in the market are likely to be of low quality (as in Eisfeldt [25]).

He also explicitly considers liquidity risk as part of his model:

The long-term investment is risky not only because of its uncertain quality but also because of the cost associated with its premature liquidation or sale. Therefore, investors are exposed to the market liquidity risk through their holding of long-term assets. Holdings of the safe asset provide partial insurance against the possibility of a liquidity shock as well as against low asset quality realizations. In addition to the value as means of storage, the safe asset has value as means for reallocating risky assets from investors who have experienced a liquidity shock to those who have not. This is similar to the concept of liquidity value for ability to transfer resources in Kiyotaki and Moore [35].

In the course of determining the implications of his model the author examines the relative roles of private information and liquidity:

As a benchmark, I examine portfolio choice when investors have private information about their investment quality but the identity of investors hit by a liquidity shock is public information. Then I analyze the situation when the investor’s type (both liquidity needs and asset quality) is private information. In the latter case investors can take advantage of their private information by selling the low-payo¤ investments and keeping the high quality ones. This generates the lemons problem: buyers do not know whether an asset is sold because of its low quality or because the seller experienced a sudden need for liquidity.

His playing with the model leads to policy recommendations:

There are policy implications for government interventions during a crisis as well as for preemptive policy regulations. The e¤ectiveness of policy responses during crises depends on which ampli…cation e¤ect contributes to a market breakdown. If it is due to an increase in liquidity preferences or to a small probability of the crisis then liquidity provision can restore the trading. However, if the no-trade outcome is caused by a large fraction of lemons or by the Knightian uncertainty about it, then it is more e¤ective to remove these low quality assets from the market. The preemptive policy response is an ex-ante requirement of larger liquidity holdings, which prevents market breakdowns during crises, especially if the economy is in the multiple equilibria range.

This last point is presumably part of the intellectual underpinnings of the Global Liquidity Standard in Basel III: A global regulatory framework for more resilient banks and banking systems. Other elements of this standard were discussed in the post Basel III.

He also provides intellectual underpinnings for a tax (deposit insurance premia?) on risky assets:

It should be noted that there is a moral hazard problem associated with government interventions during crises. If market participants anticipate government interventions then the optimal holdings of risky assets are larger. Therefore, a larger intervention is required. The moral hazard problem can be corrected if the liquidity provision at date t = 1 is …nanced by a tax τ per unit of investment, which is imposed at date t = 0. The tax τx should be equal to the amount of liquidity λ that is required to restore market price to the level of p2,

[formula]

Imposing such tax increases liquidity holdings at t = 0 and prevents market breakdowns at t = 1, leading to a higher expected utility

I find it very disappointing that the author only examines a broad tax on risky holdings at time t=0. It would be more in line with the traditional role of a central bank to determine – given plausible assumptions – the required penalty rate for liquidity provision that would optimize welfare. Additionally, the welfare cost of a higher amount of liquid holdings is not addressed. And finally, investors – and the government – are assumed to know with perfect foresight which holdings are “risky” and which holdings are “liquid”. Holders of long-term Greek government bonds might be forgiven for questioning this assumption!

This last point is acknowledged by the author in his discussion of the Panic of 2007:

Financial institutions were exposed to systemic risk through securities holdings which had skewed payo¤s: they produced high returns in normal times but incurred substantial losses during the crisis. Before the crisis, many of these created securities were rated AAA, which implied a minimal risk of default. In particular, these assets were considered very liquid: if needed, these securities could be sold at a fair market price. During the crisis, the value of securities became more sensitive to private information.

Interesting External Papers

BoC Releases December 2010 Financial System Review

The Bank of Canada has released the December 2010 Financial System Review which includes reports on:

  • The Countercyclical Bank Capital Buffer: Insights for Canada
  • Strengthening the Infrastructure of Over-the-Counter Derivatives Markets
  • Central Counterparties and Systemic Risk
  • Contingent Capital and Bail-In Debt: Tools for Bank Resolution

The Bank identifies:

Four major interconnected sources of risk emanate from the external macrofinancial environment: (i) sovereign debt concerns in several countries; (ii) financial fragility associated with the weak global economic recovery; (iii) global imbalances; and (iv) the potential for excessive risk-taking behaviour arising from a prolonged period of exceptionally low interest rates in major advanced economies. The main domestic source of risk arises from the increasingly stretched financial position of Canadian households, which leaves them more vulnerable to adverse events

They identify a central contradiction in monetary policy:

While stimulative monetary policy is needed to support the global economic recovery, experience suggests that a long period of very low interest rates may be associated with excessive credit creation and undue risk-taking as investors seek higher returns, leading to the underpricing of risk and unsustainable increases in asset prices.

One wonders if they are sending a signal by picking on the insurers:

Institutional investors with liabilities having a duration exceeding that of their assets, such as life insurance companies and defined benefit pension plans, are particularly affected by a sustained period of low interest rates. In this environment, the combination of upward pressure on the actuarial value of contractual liabilities and reduced yields on assets is likely to put pressure on the balance sheets of these entities, and potentially encourage risk-taking behaviour as these institutions strive to achieve the minimum returns they have guaranteed to policyholders and beneficiaries.

… and then return to the theme:

In Canada, household credit has continued to expand rapidly during the recession and the early stages of the recovery. While this expansion—in contrast with the experience in previous downturns and in other advanced economies—is in part a testament to the resilience of Canada’s financial system, it is also an important source of risk. The proportion of households with stretched financial positions that leave them vulnerable to an adverse shock has grown significantly in recent years, as the growth rate of debt has outpaced that of disposable income. The risk is that a shock to economic conditions could be transmitted to the broader financial system through a deterioration in the credit quality of loans to households. This would prompt a tightening of credit conditions that could trigger a mutually reinforcing deterioration of real activity and financial stability.

So there’s an inherent contradiction here. In bad times, interest rates are lowered so that people will borrow more and spend it. But now they’re worried that the borrowers won’t be able to pay it back, in sufficient numbers to cause problems of its own.

Clearly, monetary policy is too blunt a tool to do much. The bank wants to encourage borrowing and spending, sure, but it wants to encourage productive borrowing and spending – and the Wrong Type of People are exploiting monetary policy and blowing their loan proceeds on houses, beer and prostitutes instead of on productive equipement.

This becomes a political issue. Accellerated Depreciation is being tried in the US:

Tax cuts intended for businesses are a relatively small part of the $858 billion tax bill scheduled for a final vote in the Senate as early as Tuesday.

The Joint Committee on Taxation estimated that about $75 billion of the tax breaks in the plan were aimed at businesses, including $13 billion for a two-year extension of the coveted research and development credit, which helps cover the cost of wages for employees involved in research. The proposal also commits $22 billion for accelerated depreciation, which in 2011 would allow businesses to write off 100 percent of their capital expenditures immediately instead of over several years.

Many economists are skeptical of the tax breaks’ potential to stoke the economy in any meaningful way. Businesses are sitting on more than a trillion in cash, but are reluctant to invest because of lagging demand, a problem that tax incentives are not devised to address.

“The research and development credit is a good thing, with a limited effect, and the accelerated depreciation will get people to move forward with investment that they probably would have done anyway,” said David Wyss, chief economist at Standard & Poor’s. “But when you look at the amount of money involved, you’re not getting a lot of bang for your buck.”

The BoC cheerfully concludes:

The probability of an adverse labour market shock materializing is judged to have edged higher in recent months, owing to the downward revision in the October Monetary Policy Report to the outlook for the global and Canadian economies. The Bank has conducted a partial stress-testing simulation to estimate the impact on household balance sheets of a hypothetical labour market shock that would increase the unemployment rate by 3 percentage points. The results suggest that the associated rise in financial stress among households would double the proportion of loans that are in arrears three months or more. Owing to the declining affordability of housing and the increasingly stretched financial positions of households, the probability of a negative shock to property prices has risen as well.

The Bank judges that, overall, the risk of a system-wide disturbance arising from financial stress in the household sector is elevated and has edged higher since June. This vulnerability is unlikely to decline quickly, given projections of subdued growth in income.

The section on the macro-financial environment has a few interesting things to say:

The current environment has supported elevated corporate bond issuance across the credit spectrum (Chart 4). In particular, issuance of U.S.-dollar high-yield debt has reached a historic high. The search for yield has also supported increased issuance of securities with longer maturities, especially in the most recent period.(1) Owing partly to the relative strength of Canada’s banking, corporate and government sectors, demand by foreign investors for Canadian debt securities remains robust.(2) A number of Canadian issuers, including some banks and provincial governments, have taken advantage of this strong international demand for Canadian debt products by accessing markets outside Canada.

1 For instance, 45 per cent of total corporate debt issued in the Canadian market in the third quarter had a maturity of 5 to 10 years, and 9 per cent a maturity of 30 years or more, compared with averages of 32 per cent and 3 per cent, respectively, since 1999.

2 Statistics Canada data show that, in the 12-month period ending in September 2010, nonresident investors purchased $105 billion in bonds in Canadian markets, compared with $43 billion over the same period in 2009.


Click for Big

Not surprisingly, given the strength of demand, credit spreads have tightened further in Canada and in other key developed markets, although they generally remain above historical averages (Chart 5).(3) Assuming a 40 per cent recovery rate, the current spreads on North American indexes for corporate credit default swaps (CDS) imply a default rate for the next five years of 1.50 per cent per year for investment-grade issuers and 5.25 per cent per year for high-yield issuers. Based on historical data, these implied default rates, although well below the peaks reached in previous recessions, are higher than the average realized default rates.(4) Overall, this suggests that current pricing in corporate bond markets is consistent with expectations of a modest economic recovery in industrialized economies.

3 While corporate spreads in Canada and the euro area are above their levels from the early 2000s, U.S. spreads are somewhat lower, particularly for high-yield investors.

4 Default rates for high-yield issuers have peaked at about 12 per cent during every recession since 1990, and the average default rate since the 1980s has been 4.5 per cent. Moody’s reports that, for the period from 1989 to 2009, the average cumulative default rate over a five year window was 0.9 per cent for Canadian investment-grade issuers and 1 per cent for U.S. investment-grade issuers.


Click for Big

In contrast to the term extension for corporate issuers:

International banks continue to increase liquid assets and search for stable, longer-term funding, but progress has been slow. Many institutions still rely on wholesale funding, and the average maturity of new issuances has declined since the beginning of the crisis (Chart 12). Some small banks that have traditionally relied on retail deposits to finance their operations are facing stronger competition, given that the banking sector as a whole is seeking to improve the stability of its liquidity position by reducing its reliance on wholesale sources of funds.


Click for big

I’m including the next chart just because it’s cool:


Click for Big

Is monetary policy pushing on a string?

New information received since June indicates that the aggregate financial position of the Canadian non-financial corporate sector remains robust despite the recent slowdown in economic growth. The corporate sector appears well placed to withstand the financial consequences of adverse shocks. Corporate leverage declined in the third quarter of 2010, reaching the lowest ratio observed since the end of the financial crisis (Chart 23). Canadian corporate leverage, measured at market value, remains significantly below that of the United States, the United Kingdom and the euro area. Moreover, liquidity in the Canadian non-financial corporate sector—as measured by the ratio of short-term assets (less inventories) to short-term liabilities—remains elevated (Chart 24).


Click for Big
 
 
Click for Big

The individual reports are important enough that I’ll deal with them separately … some time.

Interesting External Papers

Mapping capital and liquidity requirements to bank lending spreads

The Bank for International Settlements has released a working paper by Michael R King titled Mapping capital and liquidity requirements to bank lending spreads:

This study outlines a methodology for mapping the increases in capital and liquidity requirements proposed under Basel III to bank lending spreads. The higher cost associated with a one percentage point increase in the capital ratio can be recovered by increasing lending spreads by 15 basis points for a representative bank. This calculation assumes the return on equity (ROE) and the cost of debt are unchanged, with no change in other sources of income and no reduction in operating expenses. If ROE and the cost of debt are assumed to decline, the impact on lending spreads is reduced. To recover the additional cost of meeting the December 2009 proposal for the Net Stable Funding Ratio (NSFR), a representative bank would need to increase lending spreads by 24 basis points. Taking into account the fall in risk-weighted assets from holding more government bonds reduces this cost to 12 basis points or less.

The Bank of Canada estimate was 14bp.

Interesting External Papers

FDIC Addresses Systemic Risk

Bloomberg reported today:

The FDIC board today approved two proposals for overhauling assessments for its deposit insurance fund, including one that would base the fees on banks’ liabilities rather than their domestic deposits. The fee proposal, a response to the Dodd- Frank financial-regulation law, would increase assessments on banks with more than $10 billion in assets.

The measure would increase the largest banks’ share of overall assessments to 80 percent from the present 70 percent, the FDIC said. The assessment increase would be in place by the second quarter of next year, according to the proposal.

“It’s a sea change in that it breaks the link between deposit insurance and deposits for the first time,” Acting Comptroller of the Currency John Walsh said today. “It is significant.”

The proposal would increase assessment rates on banks that hold unsecured debt of other lenders. That step was proposed to address risk that is retained in the system even as it is removed from one bank’s holdings.

It is this last bit that makes me happy. The Basel rules allow banks to risk-weight other banks’ paper as if was issued by the sovereign – which is simply craziness. The FDIC memorandum – which we can only hope will survive the comment period and spread to Canada, if not world-wide – is going to charge them extra deposit insurance premiums on the long-term portion of these assets:

Depositary Institution Debt Adjustment

Staff recommends adding an adjustment for those institutions that hold long-term unsecured liabilities issued by other insured depositary institutions. Institutions that hold this type of unsecured liability would be charged 50 basis points for each dollar of such long-term unsecured debt held. The issuance of unsecured debt by an IDI lesens the potential loss to the [Deposit Insurance Fund] in the event of an IDI’s failure; however, when such debt is hel by other IDIs, the overall risk in the system is not reduced. The intent of the increased assessment, therefore, is to discourage IDIs from purchasing the long-term unsecured debt of other IDIs.

There are many other adjustments and changes; I cannot comment on the specifics of the proposal because the data that would assist with the evaluation of the calibration of the adjustments is not available. The comments on this proposed rule will be most interesting!

Update, 2010-11-10: The FDIC has published the official notice.