Take a look at UK and US 10-year government bond yields over the past few decades and you’d struggle to say which was which. In the words of the FT last year, “The benchmark 10-year Gilt might as well be draped in the stars and stripes”. And even relatively short maturity UK and US bond yields are highly correlated. But what is behind this co-movement and does it matter?
Yuliya Baranova, Louisa Chen and Nicholas Vause.
Many investors report recent declines in market liquidity, suggesting dealers have become less willing to trade corporate bonds and other fixed-income securities due to additional costs of holding them on their balance sheets. Some fear that if asset managers began to sell these securities then prices could fall sharply. Focusing on high-yield corporate bonds, we use an econometric model to investigate whether the typical responses of dealer inventories and market prices to falls in asset manager demand have changed in recent years. We find that dealer holdings act less as a shock absorber than they did around a decade ago. Instead, bond spreads rise more. We also find that greater declines in issuance now follow these shocks.
Zijun Liu and Jamie Coen.
Non-banks are clearly important in the financial system – according to the FSB, global non-bank financial intermediation grew to $75 trillion in 2013, roughly half of banking system assets. But how are they connected to banks, and what risks does this pose? Using a new granular dataset on the exposures of banks to non-banks, we gained some important insights into what these interconnections look like in the UK. Banks’ direct credit exposures to non-banks are currently small, but there is evidence that some non-bank financial institutions have entered the core of the repo network. We found little evidence in our dataset that hedge funds are conducting risky credit intermediation, but other non-bank financial institutions seem to be leveraging up via the repo market.
David Bholat, Jonathan Grant and Ryland Thomas.
The economist John Kenneth Galbraith once quipped that the answers economists give to the question “what is money?” are usually incoherent. So in this blog we turn to law for some answers. Debate about the nature of money has been renewed by recent financial crises and the rise of digital currencies (Ali et al 2014; Desan 2014; Ryan-Collins et al 2014; Martin 2013). This was the focus of a panel session at the Bank’s recent annual conference on Monetary and Financial Law, which brought together lawyers and economists to develop interdisciplinary perspectives on topics such as money. It prompted us to think more deeply about how law does and does not constitute ‘it.’
George Kapetanios, Simon Price and Sophie Stone.
Structural breaks are a major source of forecast errors, and few come larger than the recent financial crisis and subsequent recession. After a break, formerly good models stop working. One way to cope is to discount the past in a data driven way. We try that, and find that shortly after the crash it was best to ignore almost all data older than three years – but now it is again time to take a longer view.
What did markets price in before the European Central Bank (ECB) started purchasing government bonds? This is a difficult question, but using the frequency of news articles related to ECB QE can offer an answer. Regression analysis using news flow suggests that substantial price moves in the bond, equity and foreign exchange markets in the euro area, UK and, in some cases, the US anticipated ECB QE.
Most large banks assess the capital they need for regulatory purposes using ‘internal models’. The idea is that banks are in a better position to judge the risks on their own balance sheets. But there are two fundamental problems that can arise when it comes to modelling. The first is complexity. We live in a complex world, but does that mean a complex model is always the best way of dealing with it? Probably not. The second problem is a lack of ‘events’ (eg defaults). If we cannot observe an event, it is difficult to model it credibly, so internal models may not work well.
Mike Goldby, Lien Laureys and Kate Reinold.
The natural rate of interest is usually defined as the one prevailing when economic activity is at potential and inflation is low and stable. As this has a very similar flavour to the monetary policy objective of many central banks, it is interesting to policymakers. The natural rate is unobservable and needs to be estimated. In this post, we show an estimate derived from a standard macroeconomic model which suggests that the (real) natural rate fell very sharply during the financial crisis, perhaps to as low as -6%, and that, despite a marked recovery since 2012, it remains around zero. Continue reading
Inequality sits near the top of Western politicians’ agendas and exercises the minds of academic economists and policymakers alike. While attention to the living standards of the poorest is warranted, I argue that the current focus on inequality is misplaced for two reasons: first, because inequality of outcome is of second-order economic importance compared to improving absolute living standards; and second, because it shifts attention away from tackling the inefficiencies caused by rent-seeking. Addressing these via institutional reforms would foster growth, raise the living standards of the poorest, and, as a by-product, reduce inequality.