Predicting exchange rates

Robert Czech, Pasquale Della Corte, Shiyang Huang and Tianyu Wang

Can investors predict future foreign exchange (FX) rates? Many economists would say that this is an incredibly difficult task, given the weak link between exchange rate fluctuations and the state of an economy – a phenomenon also known as the ‘exchange rate disconnect puzzle’. In a recent paper, we show that some investors in the ‘FX option market’ are indeed able to accurately forecast exchange rate returns, particularly in periods with strong demand for the US dollar. These informed trades primarily take place on days with macroeconomic announcements and in options with higher embedded leverage. We also find that two groups of investors – hedge funds and real money investors – have superior skills in predicting exchange rates.

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An unintended consequence of holding dollar assets

Robert Czech, Shiyang Huang, Dong Lou and Tianyu Wang

During the March 2020 ‘dash for cash’, 10-year gilt yields increased by more than 50 basis points. This huge yield spike was accompanied by the heavy selling of gilts by mutual funds and insurance companies and pension funds (ICPFs). Focusing on the latter group, we argue in a recent paper that ICPFs’ abnormal trading behaviour in this period was partly a result of the dollar’s global dominance: ICPFs invest a large portion of their capital in dollar assets and hedge these exposures through foreign exchange (FX) derivatives. As the dollar appreciated in March 2020, ICPFs sold large quantities of gilts to meet margin calls on their short-dollar derivative positions, contributing to the yield spike in the gilt market.

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Preferred habitat behaviour in the gilt market

Julia Giese, Michael Joyce, Jack Meaning and Jack Worlidge

Every financial market transaction has two parties, each with their own preferences. One channel through which quantitative easing works rests on these differences: preferred habitat investors value certain assets above others for non-pecuniary reasons, beyond risk and return. Central bank asset purchases of the preferred asset create scarcity, which may lead to compensating price adjustment, with spillovers to other assets and the macroeconomy. There is, however, little hard evidence on these investors. In a staff working paper, we use a new granular data set on gilt market holdings and transactions to identify groups of investors with preferred portfolio duration habitats. We present a case study suggesting that the Bank’s purchases appear to have come disproportionately from one group of these investors with a relatively strong preference for specific gilt maturities.

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What is a Bitcoin worth?

Thomas Belsham

The price of Bitcoin is currently around $57,000 (see Chart 1). But what is the price of Bitcoin based on? It’s just a bunch of code that exists only in cyberspace. It’s not backed by the state. There’s no recourse to a central authority. There’s no underlying asset, no stream of income. There’s just the thing itself. But does that mean it has no inherent worth? The code on which Bitcoin is based does give it scarcity value. Only 21 million Bitcoin will ever be created. And that might be worth something. That scarcity is why some people refer to Bitcoin as ‘digital gold’. But the very scarcity on which Bitcoin is based might also be its undoing. Its scarcity may even, ultimately, render Bitcoin worthless.

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I need a dollar, dollar, a dollar is what I need

Ambrogio Cesa-Bianchi and Fernando Eguren-Martin


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.

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Battle of the exchange funds

Max Harris

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.

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Procyclicality mechanisms in the financial system: what we know and some open questions

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.

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Decomposing changes in the functioning of the sterling repo market from 2014 to 2018

Rupal Patel

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.

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What to expect when they’re expecting

Maren Froemel, Mike Joyce and Iryna Kaminska

Introduction

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.

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A fistful of dollars: transmission of global funding shocks to emerging markets

Aakriti Mathur and Shekhar Hari Kumar

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)).

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