Archive for the ‘Financial Markets/ Finance’ Category

The recent surge in bond yields and the disconnect from fundamentals..

May 13, 2015

Despite easing policy stance, Indian govt bond yields jumped in India tracking MAT issue and global volatility. This led to certain corporates shelving plans to raise corporate bonds as well.

The rising yields have dampened the sentiment among investors. According to issue arrangers, Steel Authority of India (SAIL) and GIC Housing Finance are among companies that were planning to raise funds through private placement of bonds but have deferred the issuances after seeing the response. The yield on the 10-year benchmark government bond has hardened by 19 basis points in the last two weeks in line with global debt market yields, over concerns of rising oil prices. A weaker rupee and foreign fund outflows from the domestic share and debt markets have also been hurting.

“Due to the recent volatility of markets and upsurge in yields, companies are postponing their bond issuances. The appetite of investors has got impacted. GIC Housing Finance and SAIL postponed their issuances. Both were planning to raise three-year paper but they found the bid levels high for raising funds,” said Ajay Manglunia, senior vice-president (fixed income), Edelweiss Securities.

Similar trends are seen across some countries as well. Of all countries, Germnay has seen a jump in yields. The article says how stability breeds instability:

Central banks are getting a painful lesson in how their efforts to stabilize markets and boost their economies can, occasionally, do the opposite. The latest example is the brutal selloff in the German bond market. Yields on the 10-year German government bond, or “bund,” hit 0.67% Tuesday, up more than half a percentage point in just three weeks.

It’s hard to pinpoint a fundamental factor driving this. Yes, the European economy is doing better than expected, and Greece has, for now, avoided default or an exit from the euro as it wrangles further with its creditors over the terms of its bailout. Both factors have attenuated the “flight to safety” that made bunds so attractive.

But the main driving factor driving yields up is more technical than fundamental, and is in a strange way the result of central banks’ success in pushing yields down. Those efforts have led investors and traders to take on bigger positions, according to strategists atJ.P. Morgan. But when prices start to move against them, they respond by shrinking their positions, which can accelerate the movement in prices.

This is not the first time it’s happened. Last October, it was Treasurys, whose yields shot from 1.865% to 2.15% in a single day and eventually climbed to 2.4%. In the spring of 2013, something similar happened to Japanese government bonds.

What all three had in common, according to Nikolaos Panigirtzoglou and his colleagues at J.P. Morgan, is that all were driven by investors and traders using a risk management technique called “value at risk” (or VaR) that causes them to take on larger positions when volatility is low, because the steep price swings that inflict large losses are less likely.

Central banks have bought massive amounts of government bonds and used forward guidance to reassure investors that interest rates will remain near zero for a long time to come, a strategy aimed at lowering the cost of credit, encouraging investors and businesses to invest more, and raise inflation, which is now too low.

In the process, they have taken much of the guess work out of interest rates in recent years, causing bond market volatility to collapse. In that environment, VaR encourages traders to take on ever large positions. Markets are now heavily populated by VaR-sensitive investors: hedge funds, mutual fund managers, dealers and banks.When volatility ticks up, VaR also prods them to unwind those positions to avoid big losses, causing volatility to spike higher.

These movements are further exaggerated by the decline in bond market liquidity, i.e. the lack of dealers willing to take the other side of a client’s trade, due to a variety of structural and temporary factors. For example, dealers routinely “borrow” bonds from long-term holders such as insurance companies to facilitate their transactions. But German investors have become increasingly reluctant to lend out their precious bunds. Liquidity has been a particular problem for the futures contract on the 30-year bund, J.P. Morgan says.

“This volatility induced position cutting becomes self- reinforcing until yields reach a level that induces the participation of VaR-insensitive investors, such as pension funds, insurance companies or households,” Mr. Panigirtzoglou and his colleagues write. They refer to these episodes as “VaR shocks.”

VaR’s limitations are well known. By design it excludes or downplays rare episodes of extreme volatility. It is meant as a risk management tool, not a robotic buy or sell device. Yet VaR mimics the limitations of our own brains, which have trouble assuming circumstances that are at odds with those we have recently lived through.

Hmm.. Further:

Decades ago the late economist Hyman Minsky identified a similar phenomenon in the broader economy. A long period of steady growth with low inflation can persuade firms, workers and investors that recessions and crises are a thing of the past, and take on more risk as a result, for example by buying overvalued assets with debt.

“Stability is destabilizing,” Mr. Minsky said. He didn’t survive to see that prediction come true with a vengeance in 2008, an event Paul McCulley, then of Pimco, dubbed a “Minsky moment.”

Thus, in a larger sense, central banks’ efforts to hold down bond yields suffer from a similar shortcoming to their much bigger efforts to stabilize the economy, hold inflation low, and maximize employment. The more successful they are, the more they plant the seeds for a reversal of that success.

This is not a reason to abandon those efforts, because most of the time, they succeed (and are, in any event, better than the alternative, which is to do nothing). It is a reason to be aware of their limitations.

It also means central bankers need to be careful before assuming that market prices reflect fundamental developments. Many saw the big drop in German bond yields until mid-April as a ringing affirmation of the success of the European Central Bank’s bond-buying program. Similarly, some will see the recent selloff as evidence of failure. Neither sentiment is true.

Most of the time central banks only go wrong. The hubris they show over their control over economy only leads to huge failures later on. You keep going back to Austrians who have deplored all this rise of central banking and their interventions in economy..

Why budget and experts should not obsess over fiscal deficit target…

May 11, 2015

Sashi Sivramkrishna of NMIMS (Bengaluru) has written a much needed piece. Slightly late as Budget hype is over but nevertheless.

It says Budget should be about governance and other issues. Fiscal Deficit is an outcome dependent on many factors and is not really in control of the govt. All this obsession only leads to fiscal gimmikry as finance minister only tries to meet the target and ignores the rest.

Nations, unlike households, do not face budget constraints. Fiscal defi cit targets therefore cannot be the objective of macroeconomic policy. Instead, budget discussions must focus on governance, supply-side bottlenecks and on policies to raise aggregate demand.

….It is time that the Indian government recognises the immense policy space available to it as a sovereign nation and does not succumb to unnecessary constraints imposed on it by rating agencies and media hype. So why are myths about the need to balance budgets propagated by the economics community? One possible answer is what Samuelson once mentioned to Mark Blaug:

I think there is an element of truth in the view that the superstition that the budget must be balanced at all times [is necessary]. Once it is debunked [that] takes away one  of the bulwarks that every society must have against expenditure out of control. There must be discipline in the allocation of resources or you will have anarchistic chaos and ineffi ciency. And one of the functions of old fashioned religion was to scare people by sometimes what might be regarded as myths into behaving in away that the long-run civilised life requires (qtd in Wray 2010).

This obsession over fiscal and inflation targets has all become so stupid really. It seems nothing else matters. Just like the west, we have moved macroeconomics to just these two numbers and two institutions (fin min and central bank) which has made us miss many a things.

How a Professor of finance had a change of heart post 2008 crisis..

May 11, 2015

It is interesting to read such articles/talks on finance. Earlier it was assumed anything to do with finance was deemed good for society. Just keep bringing more and more of it. Post-2008, things have changed and has shocked many a people.

Prof Anat Admati of Stanford reflects on this change in finance and her own thinking:

I am a Finance academic. Before the financial crisis, I did research on financial markets and contracts, most recently on corporate governance. I taught finance to future managers and entrepreneurs. Before immersing in the technical details of valuing stocks, bonds, derivatives and companies, I always told my students that the financial system is really useful for society because it helps move money across time, allocate risks, and fund productive investments.

My life changed starting end of 2008. Fortunately for me, I didn’t lose my job or my house. I still do research in finance, currently on the forces that shape corporate funding decisions and how they can lead to excessive use of debt and great inefficiencies. But I am no longer in the silo I occupied and I talk to many more people both in other academic fields and outside academia. I teach a course entitled, like this conference, Finance and Society, which draws from multiple fields, including finance, economics, accounting, law, and political science. Even psychology, philosophy and sociology can bring insights.

What changed my life was seeing bad research and false or misleading claims, including from academics, affecting policy. Innocent people, powerless and often ignorant of the issues, are harmed by bad policies.

I assumed that at least academics and policymakers would welcome engagement so we can get the policy right, but I was wrong. People don’t want to engage when what you say challenges their viewpoint or actions. They may ignore and evade. I’ve witnessed not only blind spots, but what Margaret Heffernan writes about, willful blindness.

I had to step out of my silo and question my assumptions to understand better what is going on. I urge you to do the same. You can’t understand Finance and Society from any one silo.

Governance problems, when someone has control over decisions while others are impacted but don’t have enough control, are everywhere. If people can benefit at the expense of others, without facing any negative consequences, they often do just that. If people find it convenient to say false or misleading things (which they might even believe to be true) without being challenged, they often do that. If people can stay silent even if they know harm is done, they often do that, especially when staying silent pays and speaking up is personally inconvenient or worse.

Hmm..

Apart from this even the aura around finance should have declined but it has only grown. Finance professors continue to hog limelights and get fancy awards/positions based on their research (with much of it irrelevant) done before the crisis.

Common sense on the financial crisis – don’t blame financial markets

May 7, 2015
Patrick Minford of  Cardiff Univ has this piece:

Well, you get what you sow. Before the crisis there was tremendous hubris around what finance and monetary policy can do. The whole thing was to just deregulate finance and let central banks be free from govt (and be slave to finance). As both collapsed, they are all out to blame each other. The econ models may show one factor ruling over other (as is the case in this article), but we know such models have limitations. Just change a few equations and results could be very different.

The financial crisis was a combination of many things but above all it was hubris in economic and finance thinking which paved the way..

A new buzzword – frontier economies?

April 30, 2015

I was reading this recent post on capital flows from IMF in frontier economies. I assumed frontier economies to be another name for emerging economies. But no, it is a different class as explained here:

There is a group of fast-growing low-income countries that are attracting international investor interest—frontier economies. Understanding who they are, how they are different, and how they have moved themselves to the frontier matters for the global economy because they combine huge potential with big risks. 

Get to know them  

The first thing to note is that some of these countries already have moved to the lower-middle income group. While a working definition of frontier economies is subject to further discussion, broadly speaking, these countries have been deepening their financial markets, such as Bangladesh, Kenya, Nigeria, Mozambique, and Vietnam.

Some also have been able to tap the international capital markets, such as Bolivia, Ghana, Honduras, Mongolia, Nigeria, Senegal, Tanzania, Vietnam, and Zambia. Their markets are, however, not as deep and liquid as those of the emerging markets, but compared to the latter, they offer higher returns and the benefits of a diversified portfolio.

Really? Another buzzword called frontier economies. IMF is another champion in all these naming gaming and creating buzzwords.

Further:

Many frontier countries are growing at a fast pace, in most cases helped by sustained efforts to achieve macroeconomic stability, and by building business-friendly institutions ( Chart 1). These economies have also made significant efforts to lower inflation through prudent fiscal and monetary policy ( Chart 2).

Most of these countries have made progress in strengthening their policy making apparatus, reducing excessive red tape and lowering trade restrictions. Reforms to change their economic structure have helped them unlock their potential, including  greater weight on the services sector, such as in Tanzania and Kenya.

In many countries, alleviation of their debt burden over the past decade has freed up money for investments in physical and human capital. Several countries received debt relief under the Highly Indebted Poor Country Initiative, but others reduced their debt outside this initiative, such as Kenya, Mongolia, Nigeria, and Vietnam.

These countries have deepened their financial markets at a fast pace—they offer more domestic financial services and products than their peers. Some have attracted international investor interest in their domestic bonds market and several have issued sovereign bonds in the international capital markets ( Chart 3).

Access to international capital markets means these countries can attract financing to address gaps in infrastructure, such as roads and railways, which could provide further impetus to growth. But as described below, market access also poses new financial risks that countries need to carefully manage.

Influences from outside their borders

Low interest rates combined with advanced economies shedding debt have pushed investors to search for higher returns on their investments, which has expanded their interest to invest in frontier economies.

The quest for resources by emerging economies has contributed to improved terms of trade and a surge in both domestic and foreign investment in resource-rich countries, such as Bolivia, Ghana, Nigeria, and Mongolia.

Domestic public investment has increased as the low debt burden, favorable external borrowing rates, and high commodity prices have increased access to private financing sources outside their borders. 

Just another group of countries which have shown some recent promise.  And all these are countries which soon are called lost ones as well..

Could machines put Central Bankers out of a job?

April 28, 2015

Interesting post reviewing  a paper by Prof. Randall Kroner. He says technology could make jobs of banks and central banks irrelevant. So what Milton Friedman espoused technology can achieve:

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How China’s Asian Infrastructure Investment Bank is going to recast global development finance politics..

April 23, 2015

Nice summary of what AIIB will do to politics around world development finance.

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Should monetary policy take into account risks to financial stability?

April 15, 2015

Blogger Bernanke does not think so. He says financial regulation is the best way to manage financial stability, even if it is limited in scope.

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India’s stock market boom..much ado about nothing

April 10, 2015

Blogging has been absent for few days and likely to remain weak for sometime. ME is on a longish break and blogging shall not be as regular.

Anyways, Dhiraj Nayyar has a piece in Bloomberg on what is the the single most important achievment of India’s new govt – stock market boom. He calls it giving  electricity to India’s stock markets.

If Prime Minister Narendra Modi has delivered one thing in his first ten months in office, it’s been electricity to India’s stock markets. India’s benchmark Bombay Stock Exchange (BSE) Sensex recorded a31 percent jump in 2014. Only the insane runup in Shanghai’s bourse — up 90 percent in the past 12 months — has overshadowed the Indian rally.

Unfortunately, very few actual Indians stand to benefit from the boom. The proportion of retail investors in India’s equities markets is strikingly low. Less than 1.5 percent of the population invests in securities, compared with almost 10 percent in China and 18 percent in the U.S. Just 2 percent of India’s household savings are exposed to equity; in the U.S., the long-term average is 45 percent.

This is ultimately bad news for India’s economy. The country desperately needs to channel more household savings into equities — which are a vital source of corporate finance — and away from unproductive investments in gold and real estate. India also needs more local funds if it’s to sustain the strength in its equities market while avoiding macroeconomic imbalances. At the moment, around 70 percent of the market isdominated by foreign institutional investors.

Consider this statistic. Between September 2008 and October 2014, those foreign investors made net purchases of $45 billion. In the same period, domestic institutional investors (mostly funded by retail investors) made net sales of $16 billion. This imbalance creates serious side effects. The billions of dollars flowing in produce upward pressure on the rupee and a decline in India’s competitiveness. When they flow out, usually at short notice, markets collapse and the exchange rate grows volatile. That scenario is almost certain to play out in coming months when the U.S. Fed tightens monetary policy.

Well, all this has been known for a while now.

This blog itself has regularly written on how stock markets have become the single most important agenda for any govt and particularly this govt. How so few Indians are connected to stock markets but still it gets priority as media and views are shaped by people who have such large stakes in the stock market. In the 1.5% of population, majority is all the big powerful guys. It is all about media shaping views as likes of Chomsky have shown over the years.

Infact this is how all we look at economic policymakers. The music should just go on. Those who enable the show get all kinds of accolades and praises. Those who don’t or are ublucky are just ignored no matter how much their contribution is..

The continuous media speculation over rifts between Indian finance ministry & central bank..

April 7, 2015

It is amusing to say the least how media continues to cook stories over rifts between Indian finance ministry and central bank. One day there is a rift and just the next day the rifts are bridged.

First and foremost, central bank independence is a very strong and wrong term. At best, one can talk about central bank autonomy like any other public sector organisation. The broad objectives are set by the government and central bank tries to work towards them. In terms of autonomy, the idea is that the govt does not interfere in day to day activity of the central bank and lets it function. When we say independence, the idea is the central bank is completely independent to do what it wishes to do which is just wrong. How can an organisation be completely independent when it is funded completely by the govt.? Moreover, all the senior appointments are made  by the govt just to provide credibility and in India’s case most are required to work at finance ministry before the central bank (and rejoin FinMin after the central bank stint to get to IMF/World Bank etc). So where is the case for independence as we mean by the term really?

Second, the word became fashionable after western economists who have tried to minimise the role of government and fiscal policy in whatever possible way. So we have lots of papers on the fancy word forgetting the basic structure of the central bank which has govt written all over it. The ignorance of central bank history has also played a major role. There is a feeling that this bank has suddenly sprung up and govt is trying to intervene in it. They forget that all central banks have been created by govt to give them control over currency and finance issues. It is nothing but a govt body. Monetary policy is much like subset of govt./fiscal policy in many ways. Those who forgot these lessons have learnt it the hard way in the recent crisis. So all this talk just creates media noise and nothing else. It is like a Principal-Agent relationship where there can be some disagreements between the two which is natural and healthy.

It is ironic (as Austrian school proponents suggest), that those who talk about independence wanting to limit govt.’s role in economy, should actually argue for a limited central bank (if at all). By taking Austrian economics out of books, we hardly discuss this aspect. We have highly overdone the control central banks have over macro variables even inflation. At best, central banks can regulated the banking system as they have a monopoly over currency/money matters.

Anyways, this continuous media focus reminds me of a joke. It is like this. There is a man who is once asked by another ” Sir are you a Chinese”? The man who is an Indian responds amusingly as no.  The question becomes a continuous one as the second man keeps asking the same question over and over again. The first man keep replying no with rising irritation. The questioning does not stop and the first man commits suicide in frustration. The second man follows him in heaven and asks again. The first man says “Yes I am Chinese. Now what”? The second man quips ” Well, you don’t look like one”..

In similar vein, media keeps cooking stories over differences between the two. Is there a rift? Both the govt and central bank say no. As the question becomes repetitive, the exasperated officials say yeah there is..now what? To this the media says does not look like and game goes on..

Autonomy is fine and every management need it but independence is a highly overdone term. It makes us think of central banks as some holy cow which they are not. They are actually a central planner which continue to determine prices (interest rates) of sector they regulate. No other regulator does it anymore. But thanks to the dominance of monetary policy thinking , no one even questions why should a central bank be setting interest rates for an economy? Why can’t banks change interest rates as per their financials?

Does Microfinance Still Hold Promise for Reaching the Poor?

April 3, 2015

WB chips in on the hot issue. The research department had a discussion on status of microfinance.

Key findings:

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Are equities overvalued?

April 2, 2015

Well, they have been for a while now. With economies in a perennial doom, the so called leading indicator of equities has a different story.

Prof. Michael Spence has a piece on the same:

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The coming emerging-market debt squeeze

April 1, 2015

Andres Velasco warns about upcoming  debt squeeze in EMEs.

Consider the following scenario, one that has played out time and again in emerging-market countries. Local banks and firms go on a borrowing binge and pile up dollar-denominated debt – debt that pundits consider perfectly sustainable, as long as the local currency is strong. Suddenly, something (an increase in United States interest rates, a drop in commodity prices, a domestic political conflict) causes the local currency to drop in value against the dollar. The debt burden, measured in domestic currency, is now much higher. Some borrowers miss interest payments; others are unable to roll over principal. Financial mayhem ensues.

This is how the Latin American debt crisis of the 1980s, the Mexican Tequila crisis of 1994, the Asian debt crisis of 1997, and the Russian crisis of 1998 unfolded. It was also how the financial crisis of 2008-2009 transmitted itself to emerging markets. Every time, borrowers and lenders claimed to have learned their lesson.

Not only could it happen again today; it could happen on a much larger scale than in the past. Taking advantage of ultra-low interest rates in advanced countries, emerging-market banks and firms have been borrowing like never before. A recent paper by the Bank of International Settlements shows that since the global financial crisis, outstanding dollar credit to non-bank borrowers outside the US has risen by half, from $6 trillion to $9 trillion.

The bulk of that debt is in Asia, with China alone accounting for approximately $1 trillion. Other big dollar borrowers include Brazil (over $300 billion) and India ($125 billion). Countries such as Malaysia, South Africa, and Turkey, plus Latin America’s more financially open economies, also have rising foreign-currency debts.

This time is never different really ..

Are we still paying for giving too much policy attention to monetarists?

April 1, 2015

Brad De Long takes on Friedman and his venerated monetarist ideas.

Ideas matter. That is the lesson of Hall of Mirrors, the American economist Barry Eichengreen’s chronicle of the two biggest economic crises of the past 100 years: the twentieth century’s Great Depression and the ongoing Great Recession, from which we are still struggling ineffectually to recover.

Eichengreen is my friend, teacher, and patron, and his book is to my mind the best explanation to date of why policymakers in Europe and the United States have reacted to the most dramatic economic collapse in almost four generations with half-hearted measures and half-finished interventions.

According to Eichengreen, the Great Depression and the Great Recession are related. The inadequate response to our current troubles can be traced to the triumph of the monetarist disciples of Milton Friedman over their Keynesian and Minskyite peers in describing the history of the Great Depression.

In A Monetary History of the United States, published in 1963, Friedman and Anna Jacobson Schwartz famously argued that the Great Depression was due solely and completely to the failure of the US Federal Reserve to expand the country’s monetary base and thereby keep the economy on a path of stable growth. Had there been no decline in the money stock, their argument goes, there would have been no Great Depression.

This interpretation makes a certain kind of sense, but it relies on a critical assumption. Friedman and Schwartz’s prescription would have worked only if interest rates and what economists call the “velocity of money” – the rate at which money changes hands – were largely independent of one another.

What is more likely, however, is that the drop in interest rates resulting from the interventions needed to expand the country’s supply of money would have put a brake on the velocity of money, undermining the proposed cure. In that case, ending the Great Depression would have also required the fiscal expansion called for by John Maynard Keynes and the supportive credit-market policies prescribed by Hyman Minsky.

The debate over which interventions would be needed to put a halt to something like the Great Depression should have been a simple matter of analyzing the evidence. In economic hard times, did interest rates have little impact on the velocity of money, as Friedman suggested? Was Keynes correct when he described the concept of a liquidity trap, a situation in which easing monetary policy further proves ineffective? Is the stock of money in an economy an adequate predictor of total spending, as Friedman claimed, or is the smooth functioning of credit channels a more important factor, as Minsky argued?

This has always been the problem of economics. We hype certain individuals/ideas a bit too much. There is a lot of context, situation, local knowledge and above all luck for any policy to work. And here we do not even know whether monetarism would have worked in Great Depression. But we still bought the ideas as if they have delivered.

The dominance of Friedman’s ideas at the beginning of the Great Recession has less to do with the evidence supporting them than with the fact that the science of economics is all too often tainted by politics. In this case, the contamination was so bad that policymakers were unwilling to go beyond Friedman and apply Keynesian and Minskyite policies on a large enough scale to address the problems that the Great Recession presented.

Admitting that the monetarist cure was inadequate would have required mainstream economists to swim against the neoliberal currents of our age. It would have required acknowledging that the causes of the Great Depression ran much deeper than a technocratic failure to manage the money supply properly. And doing that would have been tantamount to admitting the merits of social democracy and recognizing that the failure of markets can sometimes be a greater danger than the inefficiency of governments.

The result was a host of policies based not on evidence, but on inadequately examined ideas. And we are still paying the price for that intellectual failure today.

The price is not just paid in US but across the world. All these ideas transmit quickly to rest of the world. What did not even work in the place where it was supposed to  work is expected to work in places where it is completely ill-suited.

David Glasner says it was not even Friedman but likes of Hawtrey and Cassel which had started the monetarism ideas. Even they did not look narrowly at interest rates alone but gave a more broader perspective saying going back to gold standard in 1920s was a really bad move. Points well taken. I mean how many of us really know the works of Cassel and Hawtrey.

All these ideas keep saying one thing – know your history…

Making sense of India’s emerging financial and monetary architecture

March 23, 2015

There are worries over the new finance bill which looks to take away certain powers from Indian central bank. Actually it is not just certain but quite a few powers. Indian central bank in future will just be like Bank of England in future responsible for just meeting the so called inflation target.  The spate of financial committees since 2006 have all suggested the same.

The traditional RBI camp have all opposed these ideas and have said why fix something which is not broken. Of course, those in finance ministry have not really cared. They have appointed committees after committees keeping RBI top brass out of the discussion. Even Planning Commission got into the act and ended up advising what RBI should do which was none of their business really. RBI obstructed the committees in whatever ways it could which did not please those in North Block. In India one has to look beyond the objective of the committees. It is highly political with those in power trying to prove their point.

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Are low bond yields a problem?

March 23, 2015

Prof Shiller says based on his research so far low bond yields do not show a crisis. But never say never:

I have been thinking about the bond market for a long time. In fact, the long-term bond market was the subject of my 1972 PhD dissertation and my first-ever academic publication the following year, co-authored with my academic adviser, Franco Modigliani. Our work with data for the years 1952-1971 showed that the long-term bond market back then was pretty easy to describe. Long-term interest rates on any given date could be explained quite well as a certain weighted average of the last 18 quarters of inflation and the last 18 quarters of short-term real interest rates. When either inflation or short-term real interest rates went up, long-term rates rose. When either fell, so did long-term rates.

We now have more than 40 years of additional data, so I took a look to see if our theory still predicts well. It turns out that our estimates then, if applied to subsequent data, predicted long-term rates extremely well for the 20 years after we published; but then, in the mid-1990s, our theory started to overpredict. According to our model, long-term rates in the US should be even lower than they are now, because both inflation and short-term real interest rates are practically zero or negative. Even taking into account the impact of quantitative easing since 2008, long-term rates are higher than expected.

But the explanation that we developed so long ago still fits well enough to encourage the belief that we will not see a crash in the bond market unless central banks tighten monetary policy very sharply (by hiking short-term interest rates) or there is a major spike in inflation.

Bond-market crashes have actually been relatively rare and mild. In the US, the biggest one-year drop in the Global Financial Data extension of Moody’s monthly total return index for 30-year corporate bonds (going back to 1857) was 12.5% in the 12 months ending in February 1980. Compare that to the stock market: According to the GFD monthly S&P 500 total return index, an annual loss of 67.8% occurred in the year ending in May 1932, during the Great Depression, and one-year losses have exceeded 12.5% in 23 separate episodes since 1900.

It is also worth noting what kind of event is needed to produce a 12.5% crash in the long-term bond market. The one-year drop in February 1980 came immediately after Paul Volcker took the helm of the Federal Reserve in 1979. A 1979 Gallup Poll had shown that 62% of Americans regarded inflation as the “most important problem facing the nation.” Volcker took radical steps to deal with it, hiking short-term interest rates so high that he created a major recession. He also created enemies (and even faced death threats). People wondered whether he would get away with it politically, or be impeached.

Regarding the stock market and the housing market, there may well be a major downward correction someday. But it probably will have little to do with a bond-market crash. That was the case with the biggest US stock-market corrections of the last century (after 1907, 1929, 1973, 2000, and 2007) and the biggest US housing-market corrections of all time (after 1979, 1989, and 2006).

It is true that extraordinarily low long-term bond yields put us outside the range of historical experience. But so would a scenario in which a sudden bond-market crash drags down prices of stocks and housing. When an event has never occurred, it cannot be predicted with any semblance of confidence.

Keep watching. We have seen many things in last few years which were least imagined in the fancy finance world..

Political economy behind resurgence of development financial institutions across the world..

March 20, 2015

Jaimini Bhagwati has a piece on this interesting development in world political economy. This time the instrument is DFIs (development financial institutions), a concept which was dying a slow death.

China has taken a lead in setting some Asia based DFIs which is crating ruffles in world polity:

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Financial inclusion – issues for central banks…

March 19, 2015

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How the banking industry breeds dishonesty?

March 12, 2015

New research on the topic.

In an experiment, people chated more when they were made aware of their identity of being a banker:

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What do investment banks do?

March 11, 2015

What were once the cynosure of all eyes are now questioned. Investment banks or I-banks have played a critical role in giving finance both a good and a bad name.

The question is what do i-banks do? How are they different from traditional banks?  Kushal Balluck of BoE  has a nice note on this:

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