In March 2020, the Covid-19 (Covid) outbreak turned the world upside down. With economies virtually shut, financial markets were an exception and remained open. However, it was not business as usual for them: the increased need to meet immediate obligations, and a more generalised increase in risk aversion, led investors to liquidate positions in favour of hard old cash. In a recent Staff Working Paper we pose that investors did not seek any type of cash but rather that the world witnessed a ‘dash for dollars’. We show that the resulting race for dollars went beyond exchange rate markets and led to selling pressure on dollar bonds in corporate bond markets, which experienced particularly large increases in spreads.
This post contributes to our occasional series of guest posts by external researchers who have used the Bank of England’s archives for their work on subjects outside traditional central banking topics.
When Britain created the Exchange Equalisation Account (EEA) in 1932, its designers had little sense of the controversy that would ensue. The previous year, Britain had suspended gold convertibility, and the volatile capital flows that followed convinced officials that they needed a tool for managing the exchange rate. The EEA – originally a fund solely for foreign exchange interventions (its remit is broader now) – seemed not only necessary but eminently reasonable. To a world in the throes of depression, however, it looked like a means to weaken sterling and reap a competitive advantage. America responded by establishing the Exchange Stabilization Fund (ESF) in what many viewed as another escalation in the conflict that was tearing the international monetary system apart.
Robert Czech, Simon Jurkatis, Arjun Mahalingam, Laura Silvestri and Nick Vause
Financial markets reflect changes in the economy. But sometimes they amplify them too. Both of these roles were evident as the Covid-19 (Covid) pandemic materialised. As the economic outlook deteriorated, risky asset prices fell in reflection of that. And those falls were amplified as some investors reacted by liquidating assets. That also amplified increases in financing costs for companies issuing new debt or equity, which could have further damaged economic prospects. Various ‘procyclical’ mechanisms contributed to this macrofinancial feedback loop, as shown in Figure 1. This post reviews findings from research about these particular mechanisms, covering (i) how they work, (ii) how strong they are and (iii) how they might be mitigated. And, where there are gaps, it suggests new research.
Repo markets form part of the plumbing of the financial system. They allow participants to borrow cash against collateral and buy back this collateral at a higher price at the end of the transaction. When there is a blockage in repo it has repercussions on financial markets. Since 2014 there have been significant changes in repo functioning, causing policymakers to question why these changes are happening and what it means for financial stability. Our paper addresses these questions. We find fluctuations in repo were driven by changes in dealers’ supply in the pre-Covid period 2014–18. We subsequently consider the possible role that the introduction of the leverage ratio played in the willingness of intermediaries to respond to demands for cash.
During 2020 the MPC announced a further £450 billion of QE purchases, slightly more than the total amount of assets purchased over the preceding ten years, taking the target QE stock to £875 billion of gilt holdings and £20 billion of sterling investment-grade corporate bonds. We study the high-frequency reaction of gilt markets to these QE announcements in light of the surprises to market expectations of the future QE path. We find the yield reactions to be broadly consistent with news about the expected medium-term stock of QE. This is in line with recent commentary, which has focused on the ‘pace of purchases’, as a faster/slower pace translated into a larger/lower stock of expected purchases, and could capture the effects of the local supply channel. The reaction to news about purchase pace could also be potentially consistent with an impact on expected liquidity premia or expected policy rates.
Emerging markets (EMs) have become more exposed to the global financial cycle in recent years. Positive liquidity shocks – that is, a loosening of global funding market conditions – have led to exchange rate appreciations, reductions in long-term bond yields, stock market booms, and increased gross capital flows to EMs (Bhattarai et al (2018)). Negative liquidity shocks on the other hand constitute a tightening of financial conditions, reducing lending and real investment (Bruno and Shin (2015) and Avdjiev et al (2018)).
Fernando Eguren-Martin, Cian O’Neill, Andrej Sokol and Lukas von dem Berge
While planes were grounded, capital flew out of emerging market economies in response to the acceleration in the spread of the virus in the early stages of the Covid-19 pandemic. Was this capital flight predictable once you account for the sudden deterioration in the global financial environment? In this post we present a model that helps to think about how financial conditions and international capital flows are linked. We then apply this methodology to events observed between March and May 2020, and find that the model predicted a large increase in the likelihood of capital flight. However, the scale of outflows was abnormally large even once the sharp tightening in financial conditions is accounted for.
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.
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.