PrefBlog

Just a quick note here … the Kansas City Fed published a paper by Craig S. Hakkio and William R. Keeton titled Financial Stress: What Is It, How Can It Be Measured and Why Does It Matter?.

One of the coefficients is the stock/bond correlation.

Correlation between returns on stocks and Treasury bonds. In normal times, the returns on stocks and government bonds are either unrelated or move together in response to changes in the risk-free discount rate. In times of financial stress, however, investors may view stocks as much riskier than government bonds. If so, they will shift out of stocks into bonds, causing the returns on the two assets to move in opposite directions. A number of studies, some for the United States and some for other countries, confirm that the correlation between stock returns and government bond returns tends to turn negative during financial crises (Andersson and others; Baur and Lucey; Connolly and others; Gonzalo and Olmo). Thus, the stock-bond correlation provides an additional measure of the flight to quality during periods of financial stress. This correlation is computed over rolling three month periods using the S&P 500 and a 2-year Treasury bond index. Also, the negative value of the correlation is used in the KCFSI, so that increases in the measure correspond to increases in financial stress.

The authors are somewhat critical of the Bank of Canada Stress Index:

It includes some variables, such as exchange rate volatility, that are more important for a small open economy like Canada’s than for the United States. It includes the slope of the yield curve, which likely reveals more about the stance of monetary policy than financial stress. And it fails to include any measures of investor uncertainty about bank stock prices.

There appears to be some predictive value in the index:

As shown in the accompanying box, high values of the KCFSI have tended to either coincide with or precede tighter credit standards over the last 20 years. This evidence suggests that changes in credit standards provide an additional channel through which financial stress may affect economic activity.

Regretably, the authors do not dicuss whether these changes in credit standards can be better predicted by other methodologies. I have the same problem with their analysis of the predictive power of the KCFSI on the value of the Chicago Fed National Activity Index.

The authors suggest that the KCFSI could be used to help time the Fed’s exit strategy for the current crisis, but are, frankly, rather unconvincing.

Anyway, the index is down again for September, after a huge decline from the October 2008 peak, but still above July 2007.

The Federal Reserve Bank of Boston has released a Public Policy Discussion Paper by Michelle L. Barnes, Zvi Bodie, Robert K. Triest, and J. Christina Wang titled A TIPS Scorecard: Are TIPS Accomplishing What They Were Supposed to Accomplish? Can They Be Improved?:

In September 1997, the U.S. Treasury developed the TIPS market in order to achieve three important policy objectives: (1) to provide consumers with a class of assets that allows for hedging against real interest rate risk, (2) to provide holders of nominal contracts a means of hedging against inflation risk, and (3) to provide everyone with a reliable indicator of the term structure of expected inflation. This paper evaluates progress toward the achievement of these objectives and analyzes prospective ways to better meet these objectives in the future, by, for example, extending the maturity of TIPS and/or the use of inflation indexes suited to particular geographic regions or demographics. We conclude by arguing that while it is tempting to consider completing markets by introducing more TIPS‐like securities indexed to inflation rates more tailored to particular demographics, our analysis suggests that TIPS indexed to CPI do, in fact, facilitate good synthetic hedges against unexpected changes in inflation for many different investors, since the various inflation measures are very highly correlated. We do, however, argue for extending the maturity of TIPS.

The authors do not assess the cost/benefit profile of TIPS issuance to Treasury as was discussed by, for instance, FRBNY CEO William Dudley earlier this year. The organization of the paper is:

Section II describes TIPS in more detail, emphasizing how they are designed to act as protection against changes in inflation, the tax implications for investors, the demographics of holders of TIPS, and other considerations relating to whether or not TIPS should yield measures of break‐even inflation rates comparable with survey measures of consumers’ inflation expectations or future realized rates of inflation. Section III outlines and evaluates the criticisms of the CPI and speaks to whether its potential mismeasurement is relevant to the efficacy of TIPS as a hedging instrument to guarantee the real return. It also discusses whether the CPI is a good measure for everyone, and whether there might be more appropriate measures for certain heterogeneous groups, along with the costs and benefits of issuing such securities. Section IV demonstrates the efficacy of TIPS as a hedge against various ex ante and ex post inflation measures, as well as the efficacy of TIPS as a short‐term versus a long‐term hedge. The final section concludes with implications for the design of the TIPS market.

There’s rather a neat section on inflation forecasting:

All of the expected inflation measures are largely backward‐looking, moving with recent actual rates of inflation and often deviating substantially from the actual inflation rates that would be experienced over the subsequent 10 years. This is not surprising: although there was concern about the effect of an overheated economy on short‐term inflation rates during the 1960s, it would have been essentially impossible at that time to forecast the oil shocks of the 1970s, or the response of the fiscal and monetary authorities to those shocks. Moreover, the notion of a vertical long‐run Phillips curve was still controversial among economists during the late 1960s and 1970s. Even if professional forecasters had foreseen the oil shocks and policy responses, they likely would have underestimated the extent of the resulting increase in inflation.

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As a result of the unforeseen shocks, and most likely also because of errors in forecasting the response of inflation to the shocks, the actual 10‐year forward CPI growth rates were much larger than 10‐year‐forward expected inflation, starting in the mid‐1960s. Figure 11 shows the difference between the FRB/US 10‐year expected inflation variable and the actual 10‐yearforward average CPU inflation rate. Forecasts of 10‐year ahead average inflation rates increasingly underpredicted the subsequent actual experienced CPI inflation during the 1960s and early 1970s, with the underprediction of the average annual inflation rate exceeding 5 percentage points by 1972.

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The authors conclude, in part:

Finally, we draw some implications for the design of the TIPS market and related financial institutions issues. We conclude that, as is, the TIPS market provides a good hedge against inflation risk and that from a cost/benefit perspective there seems little to be gained from indexing to other inflation measures—be they broader, such as the PCE deflator, or narrower, such as regional inflation measures of the CPI‐E for the elderly. A “ladder” of TIPS, with maturities linked to when money is needed for expenses, would help investors in or near retirement hedge against their nominal expenses over time. TIPS have the potential to be the backbone asset underlying inflation‐indexed annuities, but to facilitate these annuities, the maximum duration of TIPS would need to be extended. With respect to housing as an investment as opposed to a consumption good, there is room for alternative hedging instruments and they are currently available in the form of futures contracts on S&P/Case‐Shiller Metro Home Price Indexes, or forward contracts on the Residential Property Index 25‐MSA Composite (RPX).

The Bank of Canada has released a working paper by Jean-Sébastien Fontaine and René Garcia titled Bond Liquidity Premia:

Recent asset pricing models of limits to arbitrage emphasize the role of funding conditions faced by financial intermediaries. In the US, the repo market is the key funding market. Then, the premium of on-the-run U.S. Treasury bonds should share a common component with risk premia in other markets. This observation leads to the following identification strategy. We measure the value of funding liquidity from the cross-section of on-the-run premia by adding a liquidity factor to an arbitrage-free term structure model. As predicted, we find that funding liquidity explains the cross-section of risk premia. An increase in the value of liquidity predicts lower risk premia for on-the run and off-the-run bonds but higher risk premia on LIBOR loans, swap contracts and corporate bonds. Moreover, the impact is large and pervasive through crisis and normal times. We check the interpretation of the liquidity factor. It varies with transaction costs, S&P500 valuation ratios and aggregate uncertainty. More importantly, the liquidity factor varies with narrow measures of monetary aggregates and measures of bank reserves. Overall, the results suggest that different securities serve, in part, and to varying degrees, to fulfill investors’ uncertain future needs for cash depending on the ability of intermediaries to provide immediacy.

As far as corporates are concerned, they suggest:

Finally, we consider a sample of corporate bond spreads from the NAIC. We find that the impact of liquidity is significant and follows a flight-to-quality pattern across ratings. For bonds of the highest credit quality, spreads decrease, on average, following a shock to the funding liquidity factor. In contrast, spreads of bonds with lower ratings increase. We also compute excess returns on AAA, AA, A, BBB and High Yield Merrill Lynch corporate bond indices (see Figure 3) and reach similar conclusions. Bonds with high credit ratings were perceived to be liquid substitutes to government securities and offered lower risk premium following increases of the liquidity factor. This corresponds to an average effect through our sample, the recent events suggests that this is not always the case.

Corporate spreads are dealt with in more detail:

The impact of funding liquidity extends to the corporate bond market. This section measures the impact of the liquidity factor on the risk premium offered by corporate bonds. Empirically, we find that the impact of liquidity has a flight-to-quality” pattern across credit ratings. Following an increase of the liquidity factor, excess returns decrease for the higher ratings but increase for the lower ratings. Our results are consistent with the evidence that default risk cannot rationalize corporate spreads. Collin-Dufresne et al. (2001) find that most of the variations of non-default corporate spreads are driven by a single latent factor. We formally link this factor with funding risk. Our evidence is also consistent with the differential impact of liquidity across ratings found by Ericsson and Renault (2006). However, while they relate bond spreads to bond-specific measures of liquidity, we document the impact of an aggregate factor in the compensation for illiquidity.
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First, as expected, average excess returns are higher for lower ratings. Next, estimates of the liquidity coefficients show that the impact of a rising liquidity factor is negative for the higher ratings and becomes positive for lower ratings. A one-standard deviation shock to the liquidity factor leads to decreases in excess returns for AAA, AA and A ratings but to increases in excess returns for BBB and HY ratings. Excess returns decrease by 2.27% for AAA index but increase by 2.38% for the HY index. For comparison, the impact on Treasury bonds with 7 and 10 years to maturity was -4.52% and -5.42%. Thus, on average, high quality bonds were considered substitutes, albeit imperfect, to U.S. Treasuries as a hedge against variations in funding conditions. On the other hand, lower-rated bonds were exposed to funding market shocks.

However, in extreme cases the sign of the relationship for hiqh quality bonds changes:

Adding 2008 only increases the measured impact of the common funding liquidity factor on bond risk premia. Each of the regression above leads to higher estimate for the liquidity coefficient. An interesting case, though, is the behavior of corporate bond spreads. Clearly corporate bond spreads increased sharply over that period, indicating an increase in expected returns. What is interesting is that this was the case for any ratings. Figure 8 compares the liquidity factor with the spread of the AAA and BBB Merrill Lynch index. In the sample excluding 2008, the estimated average impact a shock to funding liquidity was negative for AAA bonds and positive for BBB. The large and positively correlated shock in 2008 reverses this conclusion for AAA bonds. But note that AAA spreads and the liquidity factor were also positively correlated in 1998. This confirms our conjecture that the behavior of high-rating bonds is not stable and depends on the nature or the size of the shock to funding liquidity. Note that this does not affect our conclusion that corporate bond liquidity premium shares a component with other risk premium due to funding risk. Instead, it suggests that the relationship exhibits regimes through time.