Hubble? Bubble? Valuation trouble?

Can Gao, Ian Martin, Arjun Mahalingam and Nicholas Vause

Since Covid-19-related crashes in March, major stock indices around the world have bounced back. This is despite little or no recovery in corporate earnings expectations. As a result, forward-looking price-to-earnings ratios have increased, rising above long-run average values in most large advanced economies and approaching record highs in the United States. Commenting on such valuations, some market participants have suggested there is ‘a great deal of optimism priced into the market’ and that stock prices ‘cannot defy economic gravity indefinitely’. This post takes a closer look at stock valuations, focusing on the UK, and drawing both on a textbook model and new research from academia.

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Financial shocks, reopening the case

David Gauthier

Since the tumultuous events of 2007, much work has suggested that financial shocks are the main driver of economic fluctuations. In a recent paper, I propose a novel strategy to identify financial disturbances. I use the evolution of loan finance relative to bond finance to proxy for firms’ credit conditions and single out the shocks born in the financial sector. I apply and test the method for the US economy. I obtain three key results. First, financial shocks account for around a third of the US business cycle. Second, these shocks occur around precise events such as the Japanese crisis and the Great Recession. Third, the financial shocks I obtain are predictive of the corporate bond spread.

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Machine learning the news for better macroeconomic forecasting

Arthur Turrell, Eleni Kalamara, Chris Redl, George Kapetanios and Sujit Kapadia

Every day, journalists collate information about the world and, with nimble keystrokes, re-express it succinctly as newspaper copy. Events about the macroeconomy are no exception. So could there be additional valuable information about the economy contained in the news? In a recent research paper, we ask whether newspaper stories could help to predict future macroeconomic developments. We find that news can be used to enhance statistical economic forecasts of growth, inflation and unemployment — but only by using supervised machine learning techniques. We also find that the biggest forecast improvements occur when it matters most — during stressed periods.

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Left feeling unsettled: what are settlement failures, how prevalent are they, and what do we do about them?

Gary Harper, Pedro Gurrola-Perez and Jieshuang He

What is a settlement fail?

Imagine you’ve booked tickets for a flight, and go to pick them up and pay for them on the day. You arrive at the airport but find out the airline has overbooked, and already given your ticket away. Worse yet, because you’ve missed this flight you’re going to miss an onward connection. But, you’ll likely get a replacement ticket in a day or two as compensation.

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The leverage ratio: a balance between risk and safety

Jonathan Smith

What was the root cause of the financial crisis? Ask any economist or banker and undoubtedly they will at some point mention leverage (see e.g. here, here and here). Yet when a capital requirement based on leverage — the leverage ratio requirement — was introduced, fierce criticism followed (see e.g. here and here). Drawing on the insights from a working paper, and thinking about the main criticism — that a leverage ratio requirement could cause excessive risk-taking — this seems not to have been the case.

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Wir sind die Roboter: can we predict financial crises?

Kristina Bluwstein, Marcus Buckmann, Andreas Joseph, Miao Kang, Sujit Kapadia and Özgür Şimşek

Financial crises are recurrent events in economic history. But they are as rare as a Kraftwerk album, making their prediction challenging. In a recent study, we apply robots — in the form of machine learning — to a long-run dataset spanning 140 years, 17 countries and almost 50 crises, successfully predicting almost all crises up to two years ahead. We identify the key economic drivers of our models using Shapley values. The most important predictors are credit growth and the yield curve slope, both domestically and globally. A flat or inverted yield curve is of most concern when interest rates are low and credit growth is high. In such zones of heightened crisis vulnerability, it may be valuable to deploy macroprudential policies.

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Market fragility in the pandemic era

Gerardo Ferrara, Maria Flora and Roberto Renò

Financial markets process orders faster now than ever before. However, they remain prone to occasional dysfunction where prices move away from fundamentals. One important type of market fragility is flash events. Identifying such events is crucial to understanding them and their effects. This post displays the results from a new methodology to identify these, but also longer lasting V-shaped events, as we show here with an application to three sovereign bond markets.

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Jump-starting an international currency

Saleem Bahaj and Ricardo Reis

Only a handful of currencies are regularly used for cross-border payments: the euro, the yen, the pound, the yuan and, of course, the US dollar, which dominates almost any measure of international use. But how does a currency achieve an international status in the first place? And which government policies assist in that jump-start? Economic theory and the rise of the renminbi (RMB) in the last decade offer some clues.

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First-time buyers: how do they finance their purchases and what’s changed?

John Lewis and Fergus Cumming

The changing nature of first-time buyers

Average first-time buyer (FTB) house prices have risen by 60% over the past 15 years and homeownership has fallen. How did those who bought their first home finance it and how has this changed? i) We find that average incomes of FTBs have risen. ii) But age-cohorts with the most FTBs (e.g. millennials) have recently experienced below-average income growth. iii) FTBs are therefore increasingly richer than their classmates: in 2018 they had 1.8x the mean cohort income vs. 1.5x in 2006. iv) FTBs are also taking on bigger mortgages. v) But monthly FTB mortgage payments have actually remained flat as lower interest rates and longer mortgages mean the same monthly payment can service more debt.

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Informed trading in government bond markets

Robert Czech, Shiyang Huang, Dong Lou and Tianyu Wang

Government bond yields serve as a benchmark for virtually all other rates in financial markets. But what factors drive these yields? One view is that yields only move notably when important news hit the market, for example monetary policy announcements. Others suspect that some investors have an information advantage due to their access to costly information (e.g. data providers) or more accurate interpretations of public information. In a recent paper, we show that two investor groups – hedge funds and mutual funds – have an information edge in the UK government bond (gilt) market, and that these two investor types operate through different trading strategies and over different horizons.

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