Category Archives: Financial Markets

Bitesize: More on the bond-equity correlation

Matt Roberts-Sklar.

In a previous post I showed that bond and equity returns are negatively correlated, having been positively correlated for most of the 18th-20th centuries. The time series was long (three centuries) and the chart was just for the UK, prompting two very reasonable questions: 1) does your story hold for countries other than the UK? and 2) what’s happened to this correlation recently?

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Filed under Bitesize, Financial Markets

Unto us a lender of last resort is born: Overend Gurney goes bust in 1866

John Lewis.

The 1866 collapse of Overend Gurney sparked widespread panic as investors flocked to banks and other institutions demanding their money back.  Failure to provide substantial liquidity threatened to bring down the entire financial system.  The Governors of the Bank of England asked the Chancellor to relax the constraints of the 1844 Bank Charter Act, by granting an indemnity to allow the issue of unbacked currency.  The Chancellor’s reply, and the policy response it initiated, would save the day, and go down in central banking history as pivotal in the foundation of the “lender of last resort”, a function which has been fundamental to central banking practice ever since.

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Filed under Banking, Economic History, Financial Markets, Financial Stability

The ghost of crises past, present and future: The Bank Charter Act goes on trial in 1847

Huaxiang Huang and Ryland Thomas.

The financial crisis of 1847 has often been dubbed “The trial of the Bank Charter Act  of 1844 (Morgan (1952)).  The Act sought to remedy the errors of crises past by trying to prevent the overissue of banknotes that many had felt was the major cause of previous crises in 1825 and 1837.   The Act gave the Bank of England an effective monopoly in the issue of new bank notes and those additional notes had to be backed one for one with gold.   But this had a crucial unintended consequence:  it made it difficult for the Bank to act as a lender of last resort.  When the crisis struck, the limits imposed by the Act effectively had to be suspended.

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Filed under Banking, Economic History, Financial Markets, Financial Stability

Home is where your cash flows are? UK-focused equities and the international exposure of the FTSE All-Share

Lu Liu.

Equity prices reflect the market value of public companies, making them an important indicator of the economy.  In practice, stocks by firms listed on the local stock exchange serve as the ‘domestic’ equity benchmark but this might be misleading as an indicator of the national economy:  stock markets track the performance of individual firms, including their international business.  This makes it particularly challenging to extract a signal for the UK economy from UK equity prices, as the universe of UK-listed firms tends to be very global – for instance, around 2/3 of sales represented on the FTSE All-Share are generated abroad.  So for a better read of the UK economy, I’ll look at a subset of more UK-focused stocks and other more domestically-focused UK equity indices.

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Filed under Financial Markets, New Methodologies

Bitesize: Periodicity of GBP/USD trading activities

Jihyoung Yi.

FX assets are traded continuously across the globe.  The majority of GBP/USD trades, however, are executed during typical trading hours in London and New York (NY). Saravelos and Grover (2016) find that: (i) FX moves during these hours are most highly correlated to the overall daily move; and (ii) there is statistically significant periodicity where GBP tends to depreciate in the London morning and appreciate in the NY afternoon against the US dollar.

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Filed under Bitesize, Currency, Financial Markets, Financial Stability

Does market liquidity risk affect Euro corporate bond returns more seriously in stress periods?

Wolfgang Aussenegg, Louisa Chen, Ranko Jelic and Dietmar Maringer.

Investors require compensation for holding risky assets – an example is the bond liquidity premium for holding debt assets. In stress conditions, market liquidity can evaporate and lead to disorderly movements in prices. The Bank of England’s recent Financial Stability Report (p.29) documents a decline in the market liquidity of some government and corporate bonds, accompanied by a reduction in dealer activity. Does market liquidity risk affect bond returns more seriously in stress times than in normal times? Does a higher cost of funding for dealers in stress times cause bond returns to be more sensitive to liquidity shocks? Focusing on Euro-dominated investment-grade corporate bonds, we conduct a quantitative analysis in a regime-switching model, and confirm a ‘yes’ answer to both of these questions.

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Filed under Financial Markets, Financial Stability

Bitesize: 250 years of the bond-equity correlation

Matt Roberts-Sklar.

For most of the 18th-20th centuries, government bonds usually behaved like a risky asset. When equity prices fell, bond yields rose, i.e.  bond and equity returns were positively correlated (bond prices move inversely to yields). But since the mid-2000s, bond and equity returns have been negatively correlated, i.e. bonds became a hedge for risk. Before this, the last time this correlation was near zero for a prolonged period was the long depression in the late 19th century.

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Filed under Bitesize, Economic History, Financial Markets

Inflation compensation and risk sentiment

Matt Roberts-Sklar.

Inflation breakevens and inflation swap rates have fallen a lot in recent years. Big falls have often occurred amid deteriorating risk sentiment. This isn’t a new phenomenon. Looking across markets and time periods, I show that measures of financial market inflation compensation tend to fall when risk sentiment worsens. What’s more, this effect is asymmetric – inflation compensation doesn’t rise by as much when risk sentiment improves.

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Why Unconventional Monetary Policy Works in Theory

Roger Farmer and Pawel Zabczyk.

Monetary Policy signpost

In a discussion at the Brookings Institution, Ben Bernanke quipped that ‘the problem with Quantitative Easing is that it works in practice, but it doesn’t work in theory’.  Bernanke was referring to Wallace Neutrality – a famous result from monetary theory which asserts that the size and composition of the central bank balance sheet has no effect on inflation or employment. In a new working paper we bridge the gap between practice and theory, and we show how, by intervening in asset markets, a central bank can influence both.  In our model, that intervention will unambiguously improve economic outcomes. In essence, central banks can use open market operations and trades in risky assets to insure those unable to insure themselves.

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Filed under Financial Markets, Macroeconomics, Monetary Policy

Proprietary trading: evidence from the crisis

Francesc R. Tous, Puriya Abbassi, Rajkamal Iyer, José-Luis Peydró.

What are the consequences of proprietary trading? Banks typically hold and trade a significant amount of securities, and during the financial crisis, many of these securities suffered strong price declines. How did banks react? This is precisely what we investigate for the case of Germany in a recently published paper. We find that some banks increased their investments in securities, especially for those securities that suffered price drops. This strategy delivered high returns; but at the same time, these banks pulled back on lending to the real economy, since during the financial crisis they could not easily raise new (long-term) funding. Our findings suggest that proprietary trading during a crisis can lead to less lending to the real sector.

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Filed under Banking, Financial Markets, Financial Stability