PrefBlog

So here’s the 2023-4-28 report, very late, but it’s here! I have all kinds of links to discuss, but they’ll just have to wait!

Sorry this is so late! A month-end jam-up, coupled with a very enjoyable and excellent dinner with an old friend, conspired to cause delays. I won’t be posting the results for the 28th tonight, but I’ll catch up on the weekend, I promise! (… and there’s another month-end to do for the fund, too!)

TXPR closed at 548.04, down 0.51% on the day. Volume today was 918,780, third-lowest of the past 21 trading days.

CPD closed at 10.82, down 1.19% on the day. Volume was 73,500, above the median of the past 21 trading days.

ZPR closed at 8.97, down 0.99% on the day. Volume was 197,250, above the median of the past 21 trading days.

Five-year Canada yields up a bit to 3.01% today.

Bonds were basically quiet:

The Bank of Canada did not hike interest rates earlier this month because it wanted to see more evidence of the effects of previous monetary tightening on growth and inflation, a summary of deliberations from the policy meeting showed.

Canadian inflation excluding food and energy costs is expected to remain above 3% until the fourth quarter of this year, the median forecast of seven economists surveyed by Reuters showed, which could dash hopes of an early BoC shift to cutting interest rates.

Canadian government bond yields were higher across the curve, recouping some of the previous day’s decline. The 10-year rose 3.9 basis points to 2.849%. (Reporting by Fergal Smith)

Prof Claudia Buch, Vice-President of the Deutsche Bundesbank, gave a speech:

Spring has come, but whether the crypto-asset winter is over remains to be seen. Those who see crypto-assets mainly as a conduit for illegal and gambling activities would certainly hope that turbulent spells in markets for crypto-assets have provided a salutary lesson. Those who see productive potential in these new technologies would hope that these episodes help separate the wheat from the chaff.

Which of those views prevails is an open issue. Whether crypto-assets that promise to improve the provision of financial services ultimately deliver on those promises crucially depends on the regulatory response. Which services are useful, how market structures evolve, whether new entrants are able to challenge the incumbents, what risks are associated with this – all this is shaped by regulations that apply to crypto markets.

Today, I would like to focus on the financial stability implications of crypto-assets. So far, the crypto market has been small. Market capitalisation of crypto-assets stands around 0.2% of global financial assets.

However, if there is one thing we’ve learnt from the past, it is that even seemingly small pockets of distress can breed financial crises. Crypto-assets promise innovative ways of providing financial services, just as the securitisation of financial assets did in the 1990s. Securitisation was an innovation considered to improve the allocation of risks in the financial system. It, too, started small in the 1980s, only to grow to an annual issuance volume of approximately half of outstanding mortgage and consumer loans in 2007. Similarly, the US mortgage market was considered to be of relatively minor importance – only to send shockwaves through the global financial system in 2007-08.

Here’s an opinion on economic forecasting from former chief economist of ATB Financial Todd Hirsch:

No one knows this better than economists. I’ve spent most of the past three decades working on teams within various think tanks, companies and banks, trying to forecast the economy. And I’ve concluded that it’s a waste of time. Why?

First, we’re getting worse at it. The problem isn’t faulty mathematical models or econometric techniques. Rather, the problem is the growing number of things that hit us from out of the blue – the so-called “black swan” events that are, by definition, unforeseeable.

No one in 2019 predicted a pandemic. No one in 2021 predicted a massive ground war in Europe. No one in 2022 predicted a series of bank failures. (Yes, of course, some experts had warned of all of these things, but they were nowhere on economists’ radar.) The frequency of these sorts of events is growing at an alarming rate.
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The idea that anyone can predict GDP growth to a tenth of a percentage point is hubris. A better strategy would be to prepare for any possibility. That, to a certain degree, is what economic forecasters do when we apply a “high, low and base-case” probability to a range of scenarios.

But by assigning one scenario the “base-case,” we’re still trying to convince ourselves that we can get the forecast correct. And that leads us right back to the start, where we lull ourselves into a false confidence.

Prepare for any outcome. Plan around multiple scenarios. Be ready to react swiftly as economic situations change. Don’t become complacent, thinking you know what’s going to happen.

I like this guy!

The New York Fed has updated its Corporate Bond Market Distress Index:

Corporate bond market functioning moved closer to historical norms over the month of April, with the end-of-month market-level CMDI above its historical median.

Market functioning in both the high-yield and investment-grade sectors remained roughly flat over the course of the month.

Looks like another scandal is brewing with construction loans:

The lawsuit claims StateView – founded in 2010 by brothers Dino and Carlo Taurasi with friend and chief financial officer Daniel Ciccone – repeatedly deposited cheques written on the RBC accounts into the TD accounts, and the Canadian Clearing and Settlement Systems (which handles transactions between financial institutions) conditionally credited the value of the cheques to the TD account “pending final settlement.”

TD alleges that before the transfer cleared, however, StateView moved the conditionally credited money out – either to a different account at another bank, or wire transferred it to a third party – and then stopped payment on the original RBC cheques. To avoid detection of this scheme, called cheque-kiting, TD further alleges StateView processed a large volume of “sham transactions” between other TD accounts.
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In the wake of TD’s filings, StateView is facing demands for repayment from at least two other lenders that could see an unfinished townhouse project (Nao Towns Phase II in Markham, Ont., with 96 units) pushed into insolvency.
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StateView also has several Ontario projects under construction, sold out or “fully reserved” that may now be subject to reorganization of StateView’s debts. Those include: High Crown Estates in King City (48 units), MiNu Towns in Markham (147 units), On the Mark in Markham (164 units), Elia Collection in Newmarket (72 units), Queen’s Court in Brampton (82 towns and detached homes), Elm & Co. in Stouffville (202 units) and BEA Towns in Barrie (218 units).

PerpetualDiscounts now yield 6.23%, equivalent to 8.10% interest at the standard equivalency factor of 1.3x. Long corporates yielded 4.97% on 2023-4-21 and since then the closing price has changed from 15.25 to 15.31, an increase of 39bp in price, with a Duration of 12.34 (BMO doesn’t specify whether this is Macaulay or Modified Duration; I will assume Modified) which implies a decrease in yield of about 3bp since 4/21 to 4.94%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has widened to about 315bp from the 300bp reported April 19.

John C. Williams, President and Chief Executive Officer of the New York Fed, gave a speech:

So far, tighter monetary policy from the Federal Reserve and central banks around the world is helping to bring a better balance between supply and demand. Inflation has declined in a number of sectors, particularly for many categories of commodities and goods.

In addition, the supply-chain bottlenecks that had constrained the supply of goods have largely dissipated. For example, the New York Fed’s Global Supply Chain Pressure Index has declined to a level that indicates supply pressures are now actually somewhat lower than normal. 3 I hear the same from business leaders from around the Federal Reserve’s Second District, who confirm that supply chains have improved considerably.

At the same time, data on rents for new leases provide early signs of slowing inflation for shelter. This is important because shelter inflation had been a significant driver of higher inflation over the past year.

However, despite the moderation of inflation, imbalances endure, with overall demand still exceeding supply in the economy. This is seen in the inflation rate for core services excluding housing, which has been running around 4-1/2 percent since last August.
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Because of the lag between policy actions and their effects, it will take some time for the FOMC’s actions to bring inflation down to our 2 percent target. With inflation expectations well anchored, I expect inflation to decline to around 3-1/4 percent this year, before moving to our longer-run goal over the next two years.

Turning to GDP, the data flow for the first quarter indicates that the economy continues to expand at a solid pace. I expect real GDP to grow modestly this year as tighter monetary policy continues to take effect, with growth picking up somewhat next year.

In addition, we are beginning to see some signs of cooling in the labor market. I expect slow growth will likely lead to some softening, with unemployment gradually rising to about 4 to 4-1/2 percent over the next year.

TXPR closed at 551.68, down 0.92% on the day. Volume today was 1.31-million, above the median of the past 21 trading days.

CPD closed at 10.97, down 0.63% on the day. Volume was 43,660, far below the median of the past 21 trading days.

ZPR closed at 9.10, down 0.76% on the day. Volume was 91,610, third-lowest of the past 21 trading days.

Five-year Canada yields down to 3.09% today.

The BoC has released a Staff Working Paper by John Duffy, Janet Hua Jiang and Huan Xie titled Pricing Indefinitely Lived Assets: Experimental Evidence:

We study indefinitely lived assets in experimental markets and find that the traded prices of these assets are, on average, about 40% of the risk-neutral fundamental value. Neither uncertainty about the value of total dividend payments nor horizon uncertainty about the duration of trade can account for this low traded price. An Epstein and Zin (1989) recursive preference specification that models the dynamic realization of dividend payments and incorporates risk preferences can rationalize the low traded price observed in our indefinitely lived asset market.
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In this paper, we study the trade of assets in an experimental market with indefinite horizons, consisting of an unknown number of periods. The first period begins with trade in the asset. Following trade, each unit of the asset pays its holder a fixed dividend. Thereafter, with a constant probability δ, traders’ holdings of the asset carry over to the next period, and in each new period, trade in the asset takes place and asset holders earn dividends per unit held. With probability 1 − δ, the asset ceases to exist; the asset market shuts down and the asset has no continuation value. This indefinite-horizon, or random-termination, design, initially proposed by Roth and Murnighan (1978), is the most commonly used approach in the laboratory to implementing infinite horizons with discounting.

Unlike most finite-horizon asset markets where the FV of the asset decreases over time, the stationarity associated with indefinite horizons implies that the FV of the indefinitely lived asset is constant over time.1 The stationarity associated with indefinite horizons may be a more natural setting for understanding asset pricing decisions.2

In our baseline treatment (treatment A), subjects trade in indefinite-horizon asset markets implemented by random termination (more precisely, a modified version of the block random termination scheme of Fréchette and Yuksel (2017)). In each period the market is open, subjects first trade units of a single asset. Once trading is concluded,
they receive dividend payments for each asset share they hold. Finally, a random number determines whether the asset market will continue to a new period. In each session, subjects participate in three indefinite-horizon markets (with different pre-drawn market lengths) to reveal the effect of experience, as in Smith et al. (1988). We find that traded prices are quite low, averaging around 40% of the standard FV, and they remain low even as traders gain experience. This result is rather surprising given that the vast majority of experimental asset market studies following the Smith et al. (1988) design find asset price bubbles, or prices greatly in excess of the standard FV, in the first market played, with approximate convergence to the standard FV within three market repetitions.
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As a result, we conclude that neither uncertainty about the trading horizon nor uncertainty regarding total dividend payoffs can account for the low traded prices observed in the baseline treatment A relative to the other two treatments. Instead, the experimental results suggest that the dynamic realization of dividend payments plays a critical role in accounting for the low traded price in treatment A relative to the other two treatments. In treatment A, in each trading period, subjects receive dividend payments in the current period and face an uncertain continuation value in the future. In the other two treatments, as all dividend realizations are realized after the trading is completed, subjects are more likely to view the asset as a static lottery and care about the total dividend payments.

I’ve kind of butchered this here, not including a description of how “Treatment B” and “Treatment C” differ from “Treatment A”, so those interested will just have to read the paper. Still, this does offer food for thought in the context of the current low trading prices of the current FixedReset market; and of the absurdly high prices during the issuance boom of the early 2010s.

Who wants to tweak this game to be like the FixedReset market? Say, after each round there are four mutually exclusive possibilities:

• an X% chance the game is over
• a Y% chance the dividend rate goes up by 1 unit per share
• another Y% chance the dividend rate goes down by 1 unit per share
• a (100-X-2Y)% chance there is no change in the framework of the next round

Let the play-trading begin!

TXPR closed at 556.81, up 1.30% on the day. Volume today was 4.74-million, the highest by far of the past 21 trading days, more than 2.5 times that of the second-place day.

CPD closed at 11.04, up 0.64% on the day. Volume was 204,050, the highest by far of the past 21 trading days, about 2.5 times that of the second-place day.

ZPR closed at 9.17, up 1.44% on the day. Volume was 153,210, near the median of the past 21 trading days.

Five-year Canada yields down slightly to 3.12% today.
There was some news today but broader markets were pretty calm:

Equities showed little reaction to economic data in the form of S&P Global’s flash U.S. Composite PMI Output Index, which said U.S. business activity accelerated to an 11-month high in April.
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Economic data in the euro zone also showed the region’s economic recovery unexpectedly gained steam this month, with HCOB’s flash Composite Purchasing Managers’ Index climbing to an 11-month high.
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This week, economic reports have largely pointed to a slowing U.S. economy, although comments from a host of Fed officials have indicated the central bank is still likely to hike by 25 basis points at its May meeting. Markets are currently pricing in an 85.4% chance of a 25 basis point hike at the May policy announcement, according to CME’s FedWatch Tool.
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The yield on 10-year Treasury notes was up 2.3 basis points to 3.568%.

The two-year U.S. Treasury yield, which typically moves in step with interest rate expectations, was up 0.7 basis points at 4.177%.

US Regulators are seeking to broaden the regulatory net:

The multi-regulator Financial Stability Oversight Council released the proposals for public comment just over a month after two regional bank failures sparked the biggest financial system contagion threat since the 2008 financial crisis.

U.S. Treasury Secretary Janet Yellen has raised concerns about non-bank financial institutions, including hedge funds, because of their lack of supervision and the potential for systemic spillovers from firms in distress.

Revisions to guidance on branding such firms as systemically important reverse some aspects of Trump-era changes in 2019 that made such designations more difficult.

Yellen said the new guidance removes some “inappropriate hurdles” to designating non-bank firms, causing the process to take up to six years.

“That is an unrealistic timeline that could prevent the Council from acting to address an emerging risk to financial stability before it’s too late,” she said in remarks to the FSOC meeting she chaired on Friday.

The new guidance drops 2019 requirements that FSOC assess the likelihood of a firm’s financial distress, apply an “activities-based approach” and conduct a cost benefit analysis prior to designation — which National Credit Union Administration Chair Todd described as a “Rube Goldberg-like process.”

These will be replaced with a quantitative and qualitative analysis process under which the council determines whether “material financial distress at the company or the company’s activities could pose a threat to U.S. financial stability,” a Treasury official told reporters, adding that it was not a complete return to 2012 guidance.
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FSOC’s proposed new risk assessment framework aims to enhance the council’s ability to address financial stability risks by reviewing a broad range of asset classes, institutions and activities, according to a Treasury fact sheet.

These include markets for debt, loans, short-term funds equities, digital assets and derivatives; counterparties, payment and clearing systems; and financial entities including banking institutions, broker dealers, asset managers, investment firms, insurers, and mortgage originators and services.

The new framework also specifies vulnerabilities that FSOC and member regulators would consider when evaluating potential stability risks. These include leverage, liquidity risk and maturity mismatches, market interconnections and concentration, operation risks and risk management activities.

Philip R Lane, Member of the Executive Board of the European Central Bank, gave a speech titled Monetary policy tightening and the financing of firms:

As the cost of borrowing increased and banks tightened their requirements for loan approvals, bank lending to firms has slowed. Bank credit as a share of GDP is declining – faster, in fact, than in previous tightening episodes – and markets expect it to decline significantly further this year (Chart 9). There are several factors driving this. First, the current tightening has occurred against the backdrop of adverseaggregate supply shocks. Second, the current reduction in credit supply is stronger than usual, mainlyreflecting heightened risk perceptions on the bank side. Third, the pace and size of the current policy rateincreases is extraordinary. This might imply a higher sensitivity of borrowing to rate increases at thecurrent juncture.
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The second source of external financing for firms is through corporate bond issuance. Net issuance ofdebt securities was basically flat in the first three quarters of 2022 (Chart 10). Tighter monetary policyincreases the cost of market-based debt more quickly than that of bank loans. Market-based finance became relatively more expensive in the initial tightening phase, leading to a shift from debt issuance tobank loans. However, the acceleration of the pass-through to lending rates in the last quarter of 2022 has reduced the relative attractiveness of bank loans, leading to a rebound in corporate bond issuance at theend of 2022. In February of this year, however, net issuance of corporate bonds turned negative again,meaning that firms are now issuing fewer new securities than are maturing. Together with the negative bank lending flows, this contributes to the fast decline in overall debt financing obtained by firms.

I now turn to the cost of corporate bond financing in more detail. The average yield on non-financialcorporate bonds has increased by over 300 basis points since the end of 2021. This increase is similar tothe increase in the cost of bank bond funding. It largely reflects changes in the risk-free rates due to themonetary policy tightening, as spreads – the difference between bond yields and risk-free rates – haveincreased less strongly over the same period (Chart 11). Corporate bond spreads have relativelycontained for both investment grade and high-yield securities during this tightening cycle, despite severalepisodic spikes. These bond spreads currently stand higher than in late 2021, at the beginning of ourmonetary policy normalisation cycle, but have remained roughly at the same level since June 2022.

The increase in spreads in the first half of 2022 points to increasing credit risk concerns in financialmarkets in the context of high macroeconomic uncertainty due to the Russian war against Ukraine and the energy price shock. While spreads showed some volatility since the summer of 2022, these had almost fully returned to 2021 levels before the banking turmoil triggered by the collapse of several mid-sized banks in the United States in March 2023. This episode led to a significant increase in spreads for both safer and riskier bonds, given the prevailing risk-off attitude in markets. However, spreads have already partly reversed these increases in the last few weeks.

“EUR STR” is the Euro Short Term Rate

Michelle W Bowman, Member of the Board of Governors of the Federal Reserve System, gave a speech titled Considerations for a Central Bank Digital Currency:

In broad terms, a CBDC is simply a new form of digital liability of a central bank. Because it is issued by a central bank, CBDC is typically thought of as being denominated in the currency of that central bank. One could imagine a digital U.S. dollar, a digital euro, or a digital pound. Beyond this baseline definition though, “what is a CBDC” defies a simple definition. A CBDC built on distributed ledger technology offers a wide range of design and potential use options, as well as potential risks. This variability complicates any discussion of a CBDC simply because we may not be talking about the same thing.

There are two threshold questions that a policymaker needs to ask before any decision to move forward with a CBDC. First, what problem is the policymaker trying to solve, and is a CBDC a potential solution? Second, what features and considerations—including unintended consequences—may a policymaker want to consider in deciding to design and adopt a CBDC? While it would be impossible for me to provide a comprehensive analysis of every issue surrounding CBDC, my goal today is to offer a perspective on these two threshold questions and to conclude with some thoughts about the imperative for future research on CBDCs and the potential future of CBDCs in the United States.
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One issue being examined is whether a CBDC or even broader forms of digital money could make the payment system more efficient. Do these new technologies present opportunities to increase the speed of payments and/or lower costs and frictions within the payment system?
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Another issue that some have raised is whether innovation in money and payments, including a potential U.S. CBDC, could improve financial inclusion. We can all agree that financial inclusion is an important goal when considering improvements in access to financial services, banking, and the payment system. However, in the United States today, over 95 percent of households have a least one member of the household with a banking relationship holding a checking or savings account.6 Of the remaining 4.5 percent who are not banked, nearly three-quarters have no interest in having a bank account, and approximately one-third cited a lack of trust in banks as the reason for not having a bank account. I think it is unlikely that this group would find the government somehow more trustworthy than highly regulated banks. Unbanked households are also less likely to own mobile phones or have access to the internet, which would present barriers to CBDC adoption. While there has been important research on these barriers to adoption, including consumer attitudes and technology requirements, policymakers also need to consider whether there are other means to improve financial inclusion, such as alternatives for making the distribution of government benefits more efficient and effective like promoting financial literacy.
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Another issue is whether the government should use new technologies, including a potential CBDC, to accomplish a variety of policy objectives beyond those directly related to the operating of an efficient and safe financial system. Imagine a scenario in which fiscal spending, in the form of government benefits or payments, could be transferred via CBDC and could include a limited timeframe in which they could be spent before expiring.
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As I previously noted, the introduction of the FedNow Service in the United States and other instant payments platforms globally leads me to ask: What could a CBDC accomplish, if anything, over and above what instant payments platforms alone can accomplish? There are potential use cases in the context of certain interbank transactions in wholesale markets, where some transactions are slow and heavily resource-intensive to clear and settle. Participants in the wholesale financial markets have been considering innovative ways to address these frictions with newer technologies such as distributed ledger technology in which shared information across counterparties could be leveraged to increase speed and reduce back-office costs to reconcile transactions before they settle. In the public debate about CBDC, some have argued that the introduction of a wholesale version of a CBDC could fully unlock the benefits of these newer technologies for these financial market use cases.
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In jurisdictions that have not adopted a CBDC, cash is generally the only central bank money available to the public, and it remains an important and popular means of payment. In some countries, however, digital payments have rapidly supplanted the use of cash. As a result of this trend, many central banks have cited the importance of access to central bank money by the general public as a potential reason to issue a CBDC. For example, Sir Jon Cunliffe of the United Kingdom examined the central role money plays in social and economic stability and concluded that, because private money has been replacing the use of government money over time, at some point “a retail, general purpose digital currency …will be needed in the U.K.”
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Some new private forms of money, often referred to as stablecoins, have emerged mainly to support trading in the crypto-asset ecosystem both as a means of payment and as a store of value. These stablecoins, which purport to have convertibility one-for-one with the dollar, have also been discussed as an alternative to traditional payments. However, stablecoins are less secure, less stable, and less regulated than traditional forms of money. and their structures and frameworks are opaque. To the extent stablecoins become widely used in day-to-day payments, these features could raise significant concerns. Of course, issuing a CBDC has been discussed as a potential alternative to stablecoins that could address some of these shortcomings. It is also possible that Congress could pass legislation to strengthen the regulation and oversight of stablecoins to mitigate some of these issues.

PerpetualDiscounts now yield 6.21%, equivalent to 8.07% interest at the standard equivalency factor of 1.3x. Long corporates yielded 5.10% on 2023-4-14 and since then the closing price has changed from 15.00 to 15.10, an increase of 67bp in price, with a Duration of 12.31 (BMO doesn’t specify whether this is Macaulay or Modified Duration; I will assume Modified) which implies a decrease in yield of about 5bp since 4/14 to 5.05%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has narrowed to about 300bp from the 310bp reported April 12.